INCOME SMOOTHING: ISSUES AND MENACE ON ACCOUNTING INFORMATION
This study examines, whether financial participants differently assess the financial information uncertainty associated with income smoothing depending on the degree with which income have been smoothed.
Hypothesis using annual financial reports of one hundred and ten (110) companies quoted on the Nigeria Stock Exchange for the year ended 2011 show that the based size of a firm have a positive relationship with its total accruals, but the inverse is the case with regards to the return on assets of the firm.
TABLE OF CONTENTS
CHAPTER ONE: INTRODUCTION
Background to the Study
1.2 Statement of the Research Problem
1.3 Research Objectives
1.4 Research Hypothesis
1.5 Scope of the Study
1.6 Relevance and Significance of the Study
Definitions of Terms
CHAPTER TWO: LITERATURE REVIEW
2.2 Income Smoothing Defined
2.3 Reasons for Income Smoothing
2.4 Applying Income Smoothing Through Book Entries
2.5 Book Entry Accounting and Its Effect On Information
2.6 Income Smoothing and Accrual Accounting
2.5 Total Accrual as A Measure of Income Smoothing
2.6 Impact of Board Size on Income Smoothing
2.7 Returns on Assets as a Tool for Income Smoothing
2.8 The Size of a Firm as a Determinant for Income Smoothing
2.9 Outside Directorship as a Means for Checking Income Smoothing
2.10 Theoretical Framework And Model Specification
CHAPTER THREE: RESEARCH METHODOLOGY
3.2 The Population and Sample
3.3 Data Collection Method
3.4 Sources of Data
3.5 Data Analysis Method
3.7 Limitation of the Study
CHAPTER FOUR: DATA PRESENTATION, ANALYSIS AND INTERPRETATION
4.2 Presentation of Regression Results
4.3 Test of Hypothesis
CHAPTER FIVE: RESEARCH FINDINGS, RECOMMENDATIONS AND CONCLUSION
5.2 Research Findings and Discussions
5.4 Recommendations of Future Research
BACKGROUND TO THE STUDY
Before diving into the study, Income Smoothing in Corporate Nigeria: Issues and Menace on Accounting Information, it is important to have a solid understanding of what income and accounting information are? For the purpose of this study, the researcher's definitions of income and accounting information shall be limited to corporate income, that is, income generated by business and accounting information used by businesses.
Income mostly referred to as Earnings is revenue minus cost of sales, operating expenses and taxes over a given period of time. Income according to Longman Dictionary of Contemporary English is money earned from investment. Income is the reason corporations exist, and are often the single most important determinant of a stock's price. Income is important to investors because they give an indication of the company's expected future dividends and its potentials for growth and capital appreciation. This do not necessarily means that low or negative income always indicate a bad stock; for example, many young companies report negative income as they attempt to grow quickly enough to capture a new market at which they will be even more profitable than they otherwise might have been.
Accounting Information covers information used to prepare financial statements which report the results and financial position of a business to decision makers. Owners and management use this information to judge about the results of business operations and make decisions about their management. External users like creditors, suppliers, tax authorities also use accounting information for their decision makings, that is, judging whether the business will be able to return loans, pay for goods sold, whether taxes are paid correctly and etc. For accounting information to be useful and used, they must be in compliance with fundamental accounting assumptions and conventions.
Away from the definitions of the sub-keywords; Income and Accounting Information, Income Smoothing can be defined with respect to the Investopedia Financial Dictionary as the use of accounting techniques to level out net income fluctuations from one period to the next. Baron’s Accounting Dictionary defines it as a form of income management that reflects economic results, not as they are, but rather as management wishes them to look. This results in lower earnings quality since net income does not representatively portray the economic performance of the business entity for the period. Income Smoothing relies not on falsehood and distortions, but on the wide leeway existing in alternatively accepted accounting principles and their interpretations. It is conducted within the structure of GAAP (Generally Accepted Accounting Principles). In effect, it redistributes income statements credits and charges among periods. The prime objective is to moderate income variability over the years by shifting income from good years to bad years. Future income may be shifted to the present year or vice versa. In a similar vein, income variability can be modified by shifting expenses or losses from period to period. An example is reducing discretionary cost (e. g, advertising expenses, and research and development expenses) in the current year to improve current period earnings. In the next year, the discretionary costs will be increased.
Investopedia says Income Smoothing does not rely on ‘creative’ accounting or misstatements-which would constitute outright fraud-but rather on the latitude provided in the interpretations of GAAP.
Companies indulge in the practice of Income Smoothing because investors are generally willing to pay a premium for stocks with steady and predictable earnings streams, compared to stocks whose earnings are subject to wild fluctuations. When companies come under increasing pressure during economic turbulence, managers usually turn to the accounting departments to improve the bottom line and thereby change the information content of the company. Accounting, though very flexible, does not seem to be able to supply management with useful information under these circumstances (Hope and Hope, 1996). Information for decision making is rather complex because of the multiplicity of decision makers.
Smoothing of income is a way of removing volatility in earnings by leveling off the earnings peaks over a number of years and raising the valleys over the same period. Steps are therefore taken to reduce and ‘store’ profits during slower years (Mulford and Comiskey, 2002). Income Smoothing may be successfully applied, without questions from stakeholders, either when investors are ‘naïve’ and ignore management’s ability to manipulate earnings, or ‘sophisticated’ and correctly infer management’s disclosure strategy (Kirschenheiter and Melumad,2002).
Investors may be harmed by Income Smoothing, if it is used as a strategic tool by management. Some investors do not ignore management’s ability to smooth; they are simply uninformed or ignorant.
The stewardship rendered to the shareholders by the Board of Directors of a company in line with the provisions of enabling laws and statues in the preparation and presentation of the financial statements are done alongside the auditors of the company who ensure that the financial statements so prepared reflect a true and fair view. However, one set-back lingers. Auditors are appointed by the Board of Directors; hence, they tend to do things in favour of the Directors, thus, leading to income smoothing and in the worst case, earnings management.
Examples of cases in Income Smoothing abound in the corporate world. These include;
(1) In the case of WorldCom(MCI) were capitalized operating costs shift current expenses to future period; I. e, the earnings were inflated by the capitalizing of operating expenses resulting into a boost in the firm’s earnings of about $11Billions.
(2) In the case of Cadbury Nigeria PLC were the off-balance sheet entities shift debts to special purpose entities.
In the cases above, the use of financial statements by managements as a means of discharging their fiduciary duties have exploited the flexibilities of GAAP in the preparation and presentation of financial statements. In spite of the increasing regulatory sophistication in Europe, the United State of America and even Nigeria, we are confronted with an increasing scene of fraudulent financial statements resulting from Income Smoothing.
In light of the foregoing, this work examines Income Smoothing in Corporate Nigeria: Issues and Menace on Accounting Information.
1.2 STATEMENT OF THE RESEARCH PROBLEM
Basically, it appears that two sentiments prevail when it comes to Income Smoothing. In the first case, stakeholders seem to regard Income smoothing as fraud; where as in the second case, stakeholders judge such actions to be company management using their discretion. In contrast to interpreting smoothing as an abuse of flexibility in reporting, rational managers who try to maximize the value of their firms may be using their reporting discretion, within the confines of acceptable accounting and legal requirements, to maximize the value of the companies they manage. Therefore, it all depends on the company’s management. If management wants to reach certain strategic goals to the detriment of the outside stakeholders, it will possibly be seen as fraud and certainly as self beneficial. If the information portrayed in the financial statements is changed to the detriment of the outside stakeholders, the integrity of the information may be impaired.
It is in consideration of these that the researcher seeks answers to the following questions:
What is the contribution of variable like the Board Size to the level of Income Smoothing?
2. What is the contribution of variable like the Proportion of Outside Directors to the level of Income Smoothing?
3. To what degree or extent do variable like Return on Asset affects Income Smoothing?
1.3 RESEARCH OBJECTIVES
Not too many research works have been carried out on Income Smoothing. The purpose of this study therefore is;
(1) To ascertain the role played by the Board of Directors in Income Smoothing.
(2) To examines how the Return on Asset are used to smooth income.
1.4 RESEARCH HYPOTHESIS
A hypothesis is a clear and specific declaration statements of a conjectural nature whose validity is to be established recourse to empirical findings (Eheduru,1998).
To ensure an empirical study of the subject matter, two important working and guiding hypotheses have been formulated by the researcher and they are;
H1: The Board Size has a positive relationship with Income Smoothing
Ho: The Board Size has a negative relationship with Income Smoothing
H1: The Proportion of outside directors has a positive relationship with Income Smoothing.
H0: The Proportion of outside directors has a negative relationship with Income Smoothing.
H1: The Return on Asset has a positive relationship with Income Smoothing.
H0: The Return on Asset has a negative relationship with Income Smoothing.
1.5 SCOPE OF THE STUDY
The scope of the study is limited to Income Smoothing in Corporate Nigeria: Issues and Menace on Accounting Information. One hundred (100) companies quoted on the Stock Exchange representing some twenty (20) sectors of the economy were considered for 2011 financial year as most corporations in Nigeria are yet to prepare and present their financial statements for the year 2012.
The data for these companies were sourced from the library of the Benin Branch of the Nigeria Stock Exchange.
1.6 RELEVANCE AND SIGNIFICANCE OF THE STUDY
This study attempts to critically examines, investigates, and finds out the factors that are responsible for increasing practice of Income Smoothing by firms in Nigeria, and to suggest ways and means of reducing or eliminating this ugly trend.
This study will therefore be beneficial to;
- Policy makers,
- Central Bank of Nigeria, the Security and Exchange Commission and the Nigeria Stock Exchange as regulators and supervisors of quoted companies,
- The Business Community,
- Financial Advisers and Analysts,
- The Public.
DEFINITIONS OF TERMS
1. Income: Earnings or profit made from business investment(s).
Income Smoothing: The deliberate tailoring of earnings to appeal to shareholders.
Accounting Information: Financial statements and reports needed by various users to make informed judgment regarding the reporting entities.
Board of Directors: A group of shareholders elected to run the organization.
Return on Assets: A ratio that shows how profitable a firm’s assets are in generating income.
Accrual Accounting: An accounting procedure that involves the recording of financial transactions that have cash consequences in the period(s) they occur rather than when the cash were actually received.
Firm Size: The size of a firm encompasses its assets base, number of its operational bases, size of its liabilities, the size of its board of directors, the range of its products and services and etc.
Getschow (1986), The Role of Book Entries in Income Smoothing and Big Baths. www.upetd.up.ac.za/../05 chapter5.pdf.
Hope, O. and Hope, S.H, (2002): Disclosure Practice in Accounting. Journal of Accounting Research 40
Inestopedia: Income Smoothing Definition. www. investopedia.com/term/i/incomesmoothing.
Kirschenheiter, M. and Melumad, N. (2002), Can Big Bath and Earnings Smoothing Co-exist as Equilibrium Financial Reporting Strategies? Journal of Accounting Research, 40(3): 761-769.
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