Abstract
Abstract Income smoothing is defined as the deliberate normalization of income in order to reach a desired trend. If the smoothing causes more information to be reflected in the stock price, it is likely to improve the allocation of resources and can be a critical factor in investment decisions. This study aims to build metrics to determine the degree of smoothing in Brazilian public companies, to classify them as smoothing and non-smoothing companies and additionally to present evidence on the long-term relationship between the smoothing hypothesis and stock return and risk. Using the Economatica and CVM databases, this study focuses on 145 companies in the period 1998-2007. We find that Brazilian smoothers have a smaller degree of systemic risk than non-smoothers. In average terms, the beta of smoothers is significantly lower than non-smoothers. Regarding return, we find that the abnormal annualized returns of smoothers are significantly higher. We confirm differences in the groups by nonparametric and parametric tests in cross section or as time series, indicating that there is a statistically significant difference in performance in the Brazilian market between firms that do and do not engage in smoothing.
Highlights
Earnings management has been the subject of extensive accounting and financial research over the past three decades
The international literature, works on the relationship between market returns and the degree of income smoothing in business include those of Michelson, Jordan-Wagner and Wooton (1995, 1999), Booth, Kallunki and Martikainen (1996), Bin, Wan and Kamil (2000), Iñiguez and Poveda (2004), Bao and Bao (2004), Tan and Jamal (2006), Tucker and Zarowin (2006) and Grant, Markarian and Parbonetti (2007), analyzing the American, Finnish, Malay and Spanish markets
In this paper we study the effect of income smoothing on the Brazilian market to verify whether there is an association between the degree of income smoothing and the level of risk and shareholder return
Summary
Earnings management has been the subject of extensive accounting and financial research over the past three decades. Booth et al (1996) studied the Finnish market to see if abnormal return, as derived from earnings disclosures, was different between companies that do and do not show smoothing behavior, based on the variation coefficient method. They obtained results showing a behavior pattern of returns and beta related to the degree of smoothing (variation of earning in this study were adjusted discretionarily) Their empirical evidence suggests that smoothers obtain better returns in the capital market than non-smoothers do. Several studies (Chalayer, 1994; Iñiguez & Poveda, 2004; Michelson et al, 1995, 2001) have obtained empirical evidence supporting the hypothesis that income smoothing is used to reduce the variability of the results and cash flows as a means of reducing perceived risk of the company (beta). This theory, qualified as positive according to Watts and Zimmerman (1986), explains accounting policies by the opportunistic behavior of managers, driven by the goal of maximizing their own earnings
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