The effect of income smoothing on the informativeness of stock price

Abstract

PurposeThe 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/approachThis 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).FindingsThe 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/valueAlthough 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.