17
The Effect of Income Smoothing and Earnings Quality on
Financial Performance of Firms
1UMOBONG, Asian Asian, FCA &
2OGBONNA, G.N, PhD, FCA
1Department of Accounting, Faculty of Management Science
University of Port Harcourt, Port Harcourt
Rivers State, Nigeria
Email: [email protected]; GSM: +23477881419
2Department of Accounting, Faculty of Management Science
University of Port Harcourt, Port Harcourt,
Rivers State, Nigeria
Email: [email protected]; GSM: +2348037063699
ABSTRACT The study evaluated the effect of Income smoothing and earnings quality on performance of
pharmaceutical firms Quoted on Nigeria Stock Exchange using secondary data between 2006 and
2014. The firms were categorized into smoother and non-smoother firms and assessed as to whether
performance variables Price earnings ratio, Return on total assets and Return on equity are influenced
by income smoothing and earnings quality using ANOVA and Independent T test. Findings indicate
weak, insignificant and non-linear relationship between earnings quality and P/E ratio implying that
earnings quality does not influence price of shares. Earnings quality have a linear relationship and
significantly correlate with ROE and ROA with negative coefficient. Also, the inverse relationship
indicates increase in earnings quality decreases ROE and ROA. This confirms that improved quality of
earnings mitigates earnings management and reduces bloated earning thereby improving accounting
quality. Study also confirmed no significant difference of ROA and P/E of smoother and non-
smoother firms implying that smoothing does not alter the market price of shares and do not affect
return on assets. These results may be influenced by market perception and other factors that interplay
in the market place such as forces of demand and supply. We recommend based on the significant
effect of earnings quality on ROA and ROE that management should strengthen internal controls,
enhance corporate governance and comply fully with accounting standards while curbing excessive
use of discretional powers by managers.
Keywords: Income Smoothing, Earnings Quality, Price Earnings Ratio, Returns on Asset, Returns on
Equity
INTRODUCTION
Income Smoothing and earnings quality has continued to attract research interest in contemporary
times. The reason is not far- fetched. Investors continue to rely on accounting numbers in making
investment decisions. Decision making is not limited to investors. Creditors as well as other users of
financial statements rely on the accounting statements to evaluate the performance of the firm.
Creditors are interested in the performance of the firm as this signals the ability of the entity to exist as
a going concern thus meeting its maturing obligations‟ and fulfilling the debt covenants. The behavior
of management in the preparation of financial statement and presentation of the performance of the
firm will determine the extent of reliance which the various users make on the financial statement.
Researchers have shown that investors tend to patronize firms with stability of earnings as this will
reduce risk and guarantee income from the investment. Firms with high volatility in earnings are
known to be riskier than others with stable earnings. Managers having been aware of the behavior of
investors are more inclined to earnings smoothening so that investor‟s perception about the company
International Journal of Business & Law Research 5(1):17-29, Jan.-Mar., 2017
© SEAHI PUBLICATIONS, 2017 www.seahipaj.org ISSN: 2360-8986
18
could be plausible. With Stability of earnings management believes patronage and good reputation of
the company can be guaranteed within the framework of acceptable accounting principles
The flexibility and freedom of choice of accounting methods implies that Managers will choose
accounting methods that impact on timing of income and revenue to suit the purpose of stability of
earnings so as to motivate investors. How then does smoothening and quality of earnings affect the
performance of firms quoted in the Nigerian stock Exchange? This research work attempts to answer
this question and investigate the effect of Smoothening of income and quality of earnings on
performance of quoted firms in Nigeria stock exchange.
Statement of the Problem
The objective of financial reporting is to provide information about financial position, performance
and changes in financial position of an entity that is useful in making economic decision for a wide
range of users such as investors, employees, lenders, suppliers, customers, government and the general
public. Penman (2002) says that accounting quality should be discussed in terms of shareholders
interest and fair valuation of that interest. This then raises the question of fairness as to the impact of
income smoothening, earnings quality manipulation and whether this attitude of managers‟ best serves
the interest of investors. In addition, how does this manipulation of earnings affect the performance of
the firm? Financial reporting abuses such as healthsouth, Adelphia, Enron, worldcom, have raised
questions about the quality of accounting information (Wahlen et al 2010) and the impact of such
manipulations on the performance of firms. In Nigeria, the case of Cadbury, the failure of banks and
the stock market crash and depression of stock prices leading to huge investment losses by investors
places a bold question mark on financial reporting and wets the appetite of researchers on the need to
investigate Managers action and reported effects on performance of firms
Prior research documents that managers deliberately influence financial reporting system by
disclosing earnings numbers that satisfy projected benchmarks (Burgstahler & Dichev (1997);
Zeckhauser & Patel (1999)); Grinaker (1994); Bushee (1998); (Tapia & Fernández, 2007). It is
believed that the more sustainable the earnings the higher the quality while according to Joo (1991)
there have been some motivations for the phenomenon of income smoothing, such as Increasing
shareholders‟ welfare, facilitating the capability of predicting income and enhancing the manager‟s
welfare. Previous studies were mainly in Industrialized and Asian nations with little or no empirical
research in third world economies such as Nigeria. This affects generalization due to cultural,
economic and technological disparity between countries researches were conducted and the Nigerian
setting. Furthermore, most of the studies were conducted under GAAP. With the introduction of
International Accounting Standards (IFRS) there is the need to revisit some of these study areas as the
application of standards could impact on reporting behavior of firms which were non-existent under
GAAP and may probably impact on outcome of study. In Nigeria there is paucity of study about the
effect of smoothening and earnings quality on the performance of firms. This study attempts to fill this
gap and establish whether firm‟s performance can be influenced by smoothing of income and earnings
quality. Also, Prior studies such as conducted by Hejazi & Ansari (2012) used price earnings ratio as
the sole performance indicator; our study uses multiple performance indicators to facilitate detailed
probing of the effects of Income Smoothing and earnings quality on different spectrum of
performance. Therefore, the aim of the study is to investigate the effect of income smoothing and
quality of earnings on the performance of quoted firms on Nigeria stock exchange.
LITERATURE REVIEW
THEORETICAL FRAMEWORK
Agency Theory
Agency theory explains the relationship between the investor and the managers. The agent (manager)
undertakes to perform certain duties for the principal (investors) and the principal undertakes to
reward the agent (Jensen & Meckling, 1976). Donaldson & Davis (1991) argued that in organization
where share ownership is widely distributed managerial behavior does not always maximize
shareholders return. Fiet (1995) argued that the degree of uncertainty about whether the agent will
pursue self-interest rather than comply with the requirements of the contract represents an agent risk
for an investor. Agency theory is based on the premise that the principal will always be interested in
the outcome generated by the agents. This underlies the importance of accounting and auditing in
Umobong & Ogbonna ….. ..Int. J. Business & Law Research 5(1):17-29, 2017
Ok
19
providing information associated with stewardship. This study is situated in Agency theory as it seeks
to establish the outcome of managerial action (agent action) on performance or output which is the
interest of the principal (investor)
Value Maximisation Theory
The value maximization theory holds that the objective of the firm is profit maximization in the short
run and wealth maximization in the long run (Friedman, 1970; Jensen 2001). The implication is that
all the activities of the entity even when they seem irrelevant are profit seeking. The theory further
explains that long run wealth maximization does not imply maximization of shareholders wealth alone
but also the maximization of wealth for other claimants such as debt holders and the associated
covenants, employees and managers (agent) .The maximization of agents wealth will definitely run in
conflict with that of the principal hence the agent principal- conflict necessitating the provision of
accounting information and auditing.
Capital Needs Theory
The theory holds that firms with growth opportunities seek external financing from the capital market
(Core, 2001). This is achieved by issuance of more shares or borrowing. This requires competition
amongst firms to obtain corporate capital as cost effective as possible under conditions of uncertainty
by disclosing more information to outside investors in order to inform them about corporate position
and increase certainty of future cash flows (Hutaibat, 2012). This information may involve smoothing
of cash flows since it is the believe that risk averse investors are more interested in investing in firms
with stability of earnings
Management Compensation Hypothesis The management compensation hypothesis states that managers who have accounting incentives, or
their remuneration that is tied up with the firm's accounting performance will tend to manipulate
accounting method and figures to show the accounting performance better than it should be .such as
managers electing to use different depreciation method allowing lower profits at the start and higher
profits towards the end. Older managers will tend to ignore any research and development costs
because it will lower current year profits affecting their income
Income Smoothing Hypothesis
Income smoothing is the levelling or averaging of income generated by entities to smooth the income
from fluctuations from period to period. It is aimed at approximating reported income over the
reporting period to create impression of stability of entities earnings. This is based on assumption that
buyers of shares are willing to invest in entities with stable earnings. It is assumed that the preference
by investors of firms with stable earnings motivate some firms to indulge in creative accounting.
.Gordon (1964) suggested that Managers could smooth income (Or security) with assumption that
stable income growth rate will be favored ahead of higher average income flows with more variations.
The following prepositions were made. First, Managers will aim to maximize utility. Secondly, utility
increase with job security, growth and level of Manager‟s income and firm size. Thirdly, the
satisfaction of shareholders motive of increasing income determines job security. Fourthly,
shareholders satisfaction depends on increases with the average rate of growth in the firms income (or
the average rate of return on its capital) and the stability of its income. It follows therefore that if the
assumptions above are justified management within the latitude provided by accounting rules will
smooth reported income as well as the rate of growth in income.
Empirical Review
Several studies have been undertaken to study Income alterations by Managers (Nonari ,2002;
Burgstahler & Dichev ,1997; Degeorge, Zeckhauser & Patel,1999)). To accomplish this, managers can
either alter the earnings number via accounting manipulations or changes to real operations. There is a
vast body of literature that investigates the management of earnings through accounting manipulations
designed to meet a variety of incentives (Healy ,1985; McNichols & Wilson,1988; DeAngelo ,1994;
Teoh, Welch & Wong ,1998; Kasznik ,1999)).
There is the belief that Managers engage in income smoothening taking actions that will reduce
fluctuations in firm‟s reported earnings. Ronen & Sadan (1981) found that managers engage in income
levelling with belief that investors prefer firms with smoother income. Lambert (1984) and Dye
(1988) showed that a risk averse Manager who is precluded from borrowing and lending in the capital
Umobong & Ogbonna ….. ..Int. J. Business & Law Research 5(1):17-29, 2017
Ok
20
market has the incentive to smooth firms reported earnings. Trueman & Tiwan (1988) contrast from
Dye & Lambert (1988) that within a market setting an incentive exists for a manager to smooth
income that is independent of either risk aversion or restricted access to capital markets. Graham et al
(2005) report “an overwhelming percentage of respondents indicate that they prefer a smooth earning
path.
Contemporary research has shown that Managers used reporting discretion which are categorized into
garbing or efficient communication of private information. Managers may smooth reported earnings to
meet bonus target (Hearly, 1985) or to protect the job (Fuderberg & Tirrole, 1995; Arya et al, 1988).
The contracting theory argues that Income garbling is an equilibrium solution because the principal
would otherwise pay a high premium to compensate the agent, who has information advantage for
taking additional risk (Lambert 1984; Demski & Frimor 1999). Under this scenario even under
efficient contract the communication has been garble and therefore the reported earnings is less
informative about a firm‟s income and cash flows.
In contrast, other studies show that managers use income smoothing to bring to the fore private
information and future earnings (kirscheneiter & Melumad, 2002); Ronen & Sandan, 1981; Demski,
1988; Sankar & Subramaanyan, 2001). The reported communication can be either active or passive.
According to kirschenheister & Melumadd (2002) the level of reported earnings permit investors to
predict level of permanent future cash flows. Fluctuation of earning increases uncertainty and reduces
ability of investors to predict permanent cash flows. The dual role motivates Managers to smooth
earnings. Ronen & Sadan (1981) argues that it is only firms with good future prospects that smooth
earnings as borrowing from the future could have negative consequences on poorly performing firm.
Michelson et al. (2000) smoother firms report higher abnormal return mean compared to non-
smoother firms. Norani (2002) income smoothing had no significant effect on the return of firms.
Furthermore, the study found nature of industry firm belongs and size of the firm can influence
abnormal accruals. Bao & Bao (2004) investigated effect of income smoothing and earnings quality
and concluded that no significant difference exist between earnings per share and share price of
smoother and non-smoother firms.
Despite rich literature on Income smoothing; few studies have been carried out in third world
countries especially in Nigeria about effect of smoothing on performance of firms. This paper attempts
to fill this gap and study the effect of smoothing and quality of earnings on performance of firms
quoted on Nigeria Stock Exchange.
RESEARCH METHODOLOGY
The study adopted longitudinal and cross sectional research design. The longitudinal design will
capture a number of years of the operations of firms by considering firms financial statements while a
cross section of the firms will be examined considering the elimination of the quoted financial
institution
Population and Sample
The population includes all Manufacturing firms listed on the Nigeria stock exchange between 2006
and 2014. The firms in this study must meet the following criteria; the firm must have full financial
data for the whole period of investigation. The firm must list on the Nigerian Stock Exchange before
.2007. They should not have interruption of transactions for more than four weeks within a financial
year. The study adopted census method that do not require sampling and considered Pharmaceutical
firms only. Secondary data was obtained from the Nigerian stock exchange and the website of the
companies under study
Data Collection Method
The data used for this study consist of financial statements of Pharmaceutical firms listed on Nigeria
stock exchange and decision at annual and extra-ordinary general meetings of the firms which are
accessible in the firm‟s websites. Other data used in this study were collected from computations using
Statistical package for social sciences (SPSS)
Variable
Income Smoothing
Prior empirical studies consider indiscriminately two methods initiated by Eckel (1981) and
Beidleman (1973) to measure earnings variability. Beiilleman‟s co-efficients (called coefficients of
Umobong & Ogbonna ….. ..Int. J. Business & Law Research 5(1):17-29, 2017
Ok
21
determination) measure the correlation of the objects of smoothing over time. Eckel‟s coefficients
(called coefficient of variation) measure the variability of the object of smoothing with its average
over time.
In Eckel‟s method, the first coefficient of variation (CVa) consist in dividing the standard deviation of
change in net income over the sample period for each firm by the mean of its changes Beatty & Harris
(1999). The second (CVb) is the standard deviation of the changes in the net income over the sample
period for each firm divided by the mean of the net Income Beatty & Petronik (2002). In this study we
have chosen the second co-efficient because it leads to the selection of a larger number of firms.
In Beidleman‟s method, the first model is linear and assumes a steady growth of the net income over
time. The second is semi-logarithmic, and supposes a constant growth of the net income over time.
However, this model eliminates the firms presenting negative income even for a single year during the
study. This study does not eliminate firms with negative income hence the rejection of the
Beidleman‟s model. A third approach is the graphical method used by Chalayer & Dumontier (1995).
This study focus on use of Eckel‟s model using Eckel (1981) index. According to Eckel index, firms
are divided into two groups, including smoother and non-smoother. The Eckel‟s index is calculated by
this formula:
Earnings Change Coefficient of Variation divided by Sales Change Coefficient of Variation
When amount of Eckel‟s index is less than 1, income smoothing occur otherwise none.
Earnings Quality
Earnings quality in this study is measured using the Sloan (1996) approach. According to this
approach, when amount of cash from operating activities (CFO) is more than accruals amount, the
firm has high earnings quality. Otherwise, it has low earnings quality
Performance
Price earnings ratio (P/E ratio), return on equity (ROE) ratio and Return on Total Asset ratio (ROTA)
represent performance. This study adopts a three prong approach unlike previous studies to measure
diverse spectrum of performance of the firm as a single approach may not reveal all the effects of
smoothing on performance.
RESULTS AND DISCUSSION
HO1: There is no relation between earnings quality and price earnings ratio of companies listed
in the Nigerian stock exchange
Table 1
Model Summary
Model R R Square Adjusted R
Square
Std. Error of
the Estimate
1 .192a .037 -.007 759.61928
a. Predictors: (Constant), EQU
Table 2: Linearity Test of the Relationship between P/E and Earnings Quality
ANOVAa
Model Sum of
Squares
df Mean Square F Sig.
1
Regression 485732.760 1 485732.760 .842 .369b
Residual 12694471.971 22 577021.453
Total 13180204.732 23
a. Dependent Variable: P/E
b. Predictors: (Constant), EARNINGS QUALITY
Umobong & Ogbonna ….. ..Int. J. Business & Law Research 5(1):17-29, 2017
Ok
22
Table 3: The Relationship between P/E and Earnings Quality
Coefficientsa
Model Unstandardized Coefficients Standardized
Coefficients
t Sig.
B Std. Error Beta
1
(Constant) 60.983 189.607 .322 .751
EARNING
SQUALIT
Y
-1140.539 1243.104 -.192 -.917 .369
a. Dependent Variable: P/E
From table 1, r = 0.192 r2
= 0.037; from table 2, p-value = 0.369 > 0.05, intercept of the equation =
60.983, slope = -1140.539, t-statistic = 0.322 < 2.0739, and from table 3, F-statistic = 0.842 < 4.30.
The 0.19 correlation coefficient (r) signifies a very weak correlation between earnings quality and
price earnings ratio, while 3.7% coefficient of determination (r2) indicates that earnings quality
explains 3.7% percent of the variation in price earnings ratio. Also the F-statistic value of 0.842 is less
than the critical value of 4.30, indicating that there is no linear relationship between earnings quality
and price earnings ratio. The 60.983 value of the intercept, means that, the average value of price
earnings ratio is 60.983 when earnings quality is zero, however the estimated slope is very important
to any prediction we wish to make here. The -1140.539 value of the slope indicates that, there is an
inverse relationship between earnings quality and price earnings ratio, which means that when
earnings quality increases by a unit, price earnings ratio will drastically decrease by -1140.539,
however, the relationship is insignificant as indicated by the coefficient of determination and most
importantly the p-value which is far above the 0.05 level of significance. Therefore, we shall not reject
the hypothesis that states that there is no significant relationship between earnings quality and price
earnings ratio.
Ho2: There is no significant relationship between earnings quality and returns on equity of
quoted firms in the Nigerian Stock Exchange
Table 4: Model Summary
Model R R Square Adjusted R
Square
Std. Error of
the Estimate
1 .504a .254 .220 .22082
a. Predictors: (Constant), EARNINGS QUALITY
Table 5: Linearity Test of the Relationship between ROE and Earnings Quality
ANOVAa
Model Sum of
Squares
df Mean Square F Sig.
1
Regression .365 1 .365 7.484 .012b
Residual 1.073 22 .049
Total 1.438 23
a. Dependent Variable: ROE
b. Predictors: (Constant), EARNINGS QUALITY
Umobong & Ogbonna ….. ..Int. J. Business & Law Research 5(1):17-29, 2017
Ok
23
Table 6: The Relationship between ROE and Earnings Quality
Coefficientsa
Model Unstandardized Coefficients Standardized
Coefficients
T Sig.
B Std. Error Beta
1 (Constant) .122 .055 2.205 .038
EQU -.989 .361 -.504 -2.736 .012
a. Dependent Variable: ROE
From table 4, r = 0.504, r2
= 0.254; from table 6, p-value = 0.012 < 0.05, intercept of the equation
=0.122, slope = -0.989, t-statistic = 2,205 > 2.0739, and from table 5, F-statistic = 7.484 > 4.30.
The 0.50 correlation coefficient signifies a moderate correlation between earnings quality and return
on equity, while 25.4% coefficient of determination (r2) indicates that earnings quality explains 25.4%
percent of the variation in return on equity. Also the F-statistic value of 7.484 is greater than the
critical value of 4.30, indicating that there is a direct or linear relationship between earnings quality
and return on equity. The 0.122 value of the intercept, means that, the average value of return on
equity is 0.122 when earnings quality is zero, however the estimated slope is very important to any
prediction we wish to make here. The -0.989 value of the slope indicates that, there is an inverse
relationship between earnings quality and return on equity, which means that when earnings quality
increases by a unit, return on equity will decrease by -0.989, however, the relationship is significant as
indicated by the p-value which is less than the 0.05 level of significance. Therefore, we fail to accept
the hypothesis that states that there is no significant relationship between earnings quality and return
on equity.
HO3: There is no significant relationship between earnings quality and Returns on total assets of
firms listed on the Nigerian Stock Exchange
Table 7:
Model Summary
Model R R Square Adjusted R
Square
Std. Error of
the Estimate
1 .719a .518 .496 .08534
a. Predictors: (Constant), EARNINGS QUALITY
Table 8: Linearity Test of the Relationship between ROTA and Earnings Quality
ANOVAa
Model Sum of
Squares
Df Mean Square F Sig.
1
Regression .172 1 .172 23.610 .000b
Residual .160 22 .007
Total .332 23
a. Dependent Variable: ROTA
b. Predictors: (Constant), EQU
Table 9: The Relationship between ROTA and Earnings Quality
Coefficientsa
Model Unstandardized Coefficients Standardized
Coefficients
T Sig.
B Std. Error Beta
1 (Constant) .051 .021 2.408 .025
EQU -.679 .140 -.719 -4.859 .000
a. Dependent Variable: ROTA
Umobong & Ogbonna ….. ..Int. J. Business & Law Research 5(1):17-29, 2017
Ok
24
From table 7, r = 0.719, r2
= 0.518; from table 9, p-value = 0.000 < 0.05, intercept of the equation
=0.051, slope = -0.679, t-statistic = 2.408 > 2.0739, and from table 8F-statistic = 23.610 > 4.30. The
0.72 correlation coefficient signpost a strong correlation between earnings quality and return on total
assets, while 51.8% coefficient of determination (r2) indicates that earnings quality explains 51.8%
percent of the variation in return on total assets. Also the F-statistic value of 23.61 is far greater than
the critical value of 4.30, indicating that there is a direct or linear relationship between earnings quality
and return on total assets. The 0.051 value of the intercept, means that, the average value of return on
total assets is 0.051 when earnings quality is zero, however the estimated slope is very important to
any prediction we wish to make here. The -0.679 value of the slope indicates that, there is an inverse
relationship between earnings quality and return on total assets, which means that when earnings
quality increases by a unit, return on total assets will decrease by -0.679, however, the relationship is
significant as indicated by the p-value which is less than the 0.05 level of significance. Therefore, we
fail to accept the hypothesis that states that there is no significant relationship between earnings
quality and return on total assets.
HO4: There is no significant difference between the annual price earnings ratio of smoother and
non-smoother companies listed on the Nigerian Stock Exchange
Table 10: The descriptive statistics of price earnings ratio of smoother compared to non-
smoother companies.
Group Statistics
SMOOTHER & NON-
SMOOTHER
N Mean Std. Deviation Std. Error
Mean
PE_RATI
O
SMOOTHER 12 10.1216 86.31261 24.91631
NON-SMOOTHER 12 -88.3986 1088.78660 314.30562
Using a level of significance of 0.05, from Table 11, the calculated T-statistic = 0.312, this value is
less than the t-distribution, with 22 degrees of freedom, which is 2.0739. Because the probability that
the price earnings ratio of smoothers is significantly different from that of non-smoothers is 0.758, we
fail to reject Ho7 and conclude that there is no evidence of a significant difference between the two
means. In other words, it is reasonable to assume that Price earnings ratio of smoothers does not
significantly differ from non-smoothers. This result suggests that there is no significant difference
between the Price earnings ratio of smoother and non-smoother companies. In addition, the p-value of
0.118, under Levene's Test for Equality of Variances in Table 11, showed that the homogeneity-of-
variance assumption for the independent samples t-test procedure is justified; meaning that
independent sample t-test procedure is appropriate for testing the hypothesis seven.
However, descriptive statistics on table 10 revealed that the mean price earnings ratio of smoothers is
positive while non-smoothers is negative, suggesting that the Eckel index is appropriate in being used
as a basis for categorizing smoothening and non-smoothening companies. The implication of the result
is that smoothers are trying as much as possible to keep earnings values positive, however this result is
not significantly different from the figures reported by non-smoothers.
Umobong & Ogbonna ….. ..Int. J. Business & Law Research 5(1):17-29, 2017
Ok
25
Table 11: Independent samples test of price earnings ratio of smoother and non-smoother companies.
Independent Samples Test
Levene's
Test for
Equality of
Variances
t-test for Equality of Means
F Sig. t df Sig. (2-
tailed)
Mean
Difference
Std. Error
Difference
95% Confidence Interval
of the Difference
Lower Upper
PE_ratio
Equal
variances
assumed
2.641 .118 .312 22 .758 98.52022 315.29168 -555.35470 752.39
Equal
variances not
assumed
.312 11.138 .760 98.52022 315.29168 -594.38263 791.42
Umobong & Ogbonna ….. ..Int. J. Business & Law Research 5(1):17-29, 2017
Ok
26
HO5: There a is no significant difference between the annual ROTA of smoother and non-
smoother companies
Table 12: The descriptive statistics ROTA of smoother compared to non-smoother companies.
Group Statistics
SMOOTHER & NON-
SMOOTHER
N Mean Std. Deviation Std. Error
Mean
ROT
A
SMOOTHER 12 .0004 .07403 .02137
NON-SMOOTHER 12 -.0169 .15669 .04523
Using a level of significance of 0.05, from Table 13, the calculated T-statistic = .348, this value is less
than the t-distribution, with 22 degrees of freedom, which is 2.0739. Because the probability that the
ROTA of smoothers is not significantly different from that of non-smoothers is 0.733, we fail to reject
Ho and conclude that there is no evidence of a significant difference between the two means. In other
words, it is reasonable to assume that ROTA of smoothers does not significantly differ from non-
smoothers. This result suggests that there is no significant difference between the ROTA of smoother
and non-smoother companies. In addition, the p-value of 0.204, under Levene's Test for Equality of
Variances in table 13, showed that the homogeneity-of-variance assumption for the independent
samples t-test procedure is justified; which implies that independent sample t-test statistical tool is
appropriate for testing hypothesis. However, from descriptive statistics on Table 12, we have a
positive mean of 0.0004 for smoothers while non-smoothers is -.0169, which is a negative mean,
suggesting that the Eckel index is appropriate in being used as a basis for categorizing smoothening
and non-smoothening companies. The implication of the result is that smoothers are trying as much as
possible to keep earnings values positive, be that as it may, it is not significantly different from the
figures reported by non-smoothers.
Umobong & Ogbonna ….. ..Int. J. Business & Law Research 5(1):17-29, 2017
Ok
27
Table 13: Independent samples test of ROTA of smoother and non-smoother companies
Independent Samples Test
Levene's Test for
Equality of
Variances
t-test for Equality of Means
F Sig. T df Sig. (2-
tailed)
Mean
Difference
Std. Error
Difference
95% Confidence
Interval of the
Difference
Lower
ROTA
Equal variances
assumed
1.710 .204 .346 22 .733 .01728 .05003 -.08646
Equal variances
not assumed
.346 15.678 .734 .01728 .05003 -.08894
Umobong & Ogbonna ….. ..Int. J. Business & Law Research 5(1):17-29, 2017
Ok
28
CONCLUSION
The study examined the effect of income smoothing and earnings quality on firm performance. Based
on findings there is no significant relation between earnings quality and price earnings ratio and we
conclude that earnings quality does not affect market price of shares of firms used in the study. There
is however significant relation between earnings quality and Returns on equity and returns on total
asset and we conclude that earnings quality affect the financial performance of firms. Our study also
revealed that there is no significant difference of mean of ROTA and annual price earnings ratio of
smoother and non-smoother companies. Thus indicating that smoothing does not influence prices of
shares and does not significantly affect return on assets. The result of Eckel index shows a positive
mean for smoothers and a negative mean for non-smoothers justifying the appropriateness of Eckel
index in classifying the firms. The result of this study should be used with caution considering the
nature of the industry which is capital intensive and heavily regulated and supervised by NAFDAC
and other regulators. It is probable that the nature of the industry affects the outcome of our result and
therefore may impact on generalization of result to other industries which do not share the same
characteristics.
REFERENCES
Arya, A. Glover, J. and Sunder, S (1998). Earnings management and the revelation principle. Review
of
Accounting Studies 3: 7–34.
Bao, B.; and D. Bao (2004). Income Smoothing, Earnings Quality and Firm Valuation”, Journal of
Business, Finance & Accounting, 31(9) & (10), pp. 1525-57.
Beidleman, C. (1973). Income smoothing: The role of management. The Accounting Review 48
(4):653–667.
Burgstahler, D. and I. Dichev (1997). “Earnings Management to Avoid Earnings Decreases and
Losses”, Journal of Accounting and Economics (December) 24:99-126
Bushee, B. (1998).The influence of institutional investors on myopic R&D investment behavior. The
Accounting Review. 73: 305-333
DeAngelo, L E. (1988). Studies on Management's Ability and Incentives to Affect the Timing and
Magnitude of Accounting Accruals.‟Journal of Accounting Research, Vol. 26 pp. 32-40
DeAngelo, L.E.(1986). Accounting Numbers as Market Valuation Substitutes: A Study of
Management Buyouts of Public Stockholders.‟ The Accounting Review, Vol. 61, No. 3 pp 400-
420.
Degeorge, F., Patel, J and Zeckhauser, R (1999), „Earnings Management to Exceed Thresholds‟, The
Journal of Business, 72(1), pp.1-33.
Demski, J. S. (1998). Performance measure manipulation. Contemporary Accounting Research 15
(3):261–285
Donaldson, L and Davis, J.H (1991). Stewardship Theory or Agency Theory: CEO Governance and
Sharehoklders Returns. Australian Journal of Management. June 1991, page 49-65
Eckel, N (1981). “The Income Statement Hypothesis Revisited” Abacus, 11, pp. 1-21.
Fiet , J.O. (1995). Reliance upon Information in the Venture Capital Industry.
Fudenberg, D., & Tirole, J. (1995). A Theory of Income and Dividend Smoothing Based on
Incumbency Rents, Journal of Political Economy (February), 75-93.
Graham, J., Harvey, C and Rajgopal, S (2005). The Economic Implications of Corporate Financial
Reporting. Journal of Accounting and Economics 40: 3-73.
Gramlich, J.D., McAnally, M.L. and Thomas, J. (2001). „Balance sheet management: the case of short-
term obligations reclassified as long-term debt‟, Journal of Accounting Research, Vol. 39, No.
2, pp. 283-95
Gul, F.A., Lung, S., & Srinidhi, B. (2000).The effect of investment opportunity set and debt level on
earnings-returns relationship and the pricing of discretionary accruals. Unpublished Working
Paper.
Healy, P.M., (1985). The Effect of Bonus Schemes on Accounting Decisions.‟ Journal of Accounting
and Economics, Vol. 7, No. 1-3 (April 1985), pp. 85-107.
Umobong & Ogbonna ….. ..Int. J. Business & Law Research 5(1):17-29, 2017
Ok
29
Hejazi, R. ZAnsari, Z and Sarikhani, M. (2012). The Impact of Earnings Quality and Income
Smoothing on the Performance of Companies Listed in Tehran Stock Exchange International
Journal of Business and Social Science Vol. 2 No. 17
Jensen, M. C., & Meckling, W. H. (1976). Theory of the Firm. Managerial Behavior, Agency Costs
and Ownership Structure. Journal of Financial Economics, 3(4), 305- 360.
Johnson, M. F., R. Kasznik, and Nelson, K.K (2001). The impact of securities litigation reform on the
disclosure of forward-looking information by high technology firms. Journal of Accounting
Research 39 (2): 297–327
Joo, H. (1991). Income Smoothing: an Asymmetric Information Approach, Doctoral Dissertation,
University of Illinois.
Kasznik, R., and Lev, B (1995). To warn or not to warn: Management disclosures in the face of an
earnings Surprise. The Accounting Review 70 (1): 113–134.
Kirschenheiter, M., and N.Melumad, N (2002). Can Big Bath and earnings smoothing co-exist as
equilibrium Financial reporting strategies? Journal of Accounting Research 40 (3): 761–796.
Kirschenheiter, M.; and Melumad, N (2004). “Earnings‟ Quality and Smoothing”, Available at: http://
SSRN.com.
Lambert, R. (1984). Income smoothing as rational equilibrium behavior. The Accounting Review 41
(4):604–618.
Levitt, A. (1998). The numbers game. Speech delivered at NYU Center for Law and Business, New
York, NY, September 28.
McNichols, M. and Wilson, G.P. (1988). „Evidence of creative accounting from the provision for bad
debts‟, Journal of Accounting Research, Vol. 26, Supplement, pp.1-33
Michelson, S.E.; Jordan-Wagner, J.; and C.W. Wootton (2000), “The Relationship Between the
Smoothing of Reported Income and Risk-Adjusted Returns”, Journal of Economics and
Finance, pp. 141–159.
Norani, H. (2002). “The Effect of Income Smoothing on Stock Return of Companies Listed in Tehran
Stock Exchange”, M.A. Thesis, Shiraz university. Sloan, R.G. (1996), “Do Stock Prices Fully
Reflect Information in Accruals and Cash Flows about Future Earnings?” The Accounting
Review, pp. 289–315
Penman, S.H., & Zhang, X.J. (2002). Accounting conservatism, the quality of earnings, and stock
returns. The Accounting Review, 77, 237-264.
Perry, S. and Grinaker, R. (1994), Earnings Expectations and Discretionary Research and
Development Spending, Accounting Horizons, 8(4), 43-51.
Ronen, J., and Sadan, S (1981). Smoothing Income Numbers: Objectives, Means, and Implications.
Boston, MA: Addison-Wesley Publishing Company.
Sankar, M., and Subramanyam, K.R (2001). Reporting discretion and private information
communication Through earnings. Journal of Accounting Research 39 (2): 365–386.
Tapia, B.; and M. Fernández (2007). “Accruals, Cash Flows and Earnings in European Privately Held
Firms”, Available at: http:// SSRN.com
Teoh, S. H., .Welch, I & Wong, T.J (1998). Earnings management and the underperformance of
seasoned equity offerings, Journal of Financial Economics 50 (October), pp: 63-99.
Teoh, S. H., I. Welch, and T. J. Wong. (1998). Earnings management and the long-run market
performance of initial public offerings. Journal of Finance 53 (6): 1935–1974.
Trueman, B., and Titman, S (1988). An explanation for accounting income smoothing. Journal of
Accounting Research 26 (Supplement): 127–139.
Umobong & Ogbonna ….. ..Int. J. Business & Law Research 5(1):17-29, 2017
Ok
