DOES INCOME SMOOTHING AFFECT STOCK MARKET PRICE VOLATILITY? AN EMPIRICAL STUDY.

• Author: Obaidat, Ahmad N.
• Position: Report

INTRODUCTION

This study is motivated by prior studies (Lev & Kunitzky, 1974; Noguer & Markarian, 2012) about the association between income smoothing and the volatility of stock market price. On the one hand, income smoothing has been an interesting subject in accounting literature in terms of its objectives, types, objects, tools, motivations, detection, and its effects on firms and stakeholders. On the other hand, stock market volatility has also been considered as one of the most attractive subjects in finance literature. But, the likely effect of income smoothing on stock market prices volatility required more attention because only few studies highlight this possible association. Noguer and Markarian (2012) argued that the relation between income smoothing and stock market volatility is not clear a priori because previous studies provided only indirect evidence regarding this issue. Two years after, Okicic (2014) and Omorokunwa and Ikponmwosa (2014) also pointed out that there were relatively little empirical studies on the volatility of stock prices, especially in emerging stock markets.

Koima, Mwita, and Nassiuma (2015) highlighted the importance of studying stock market volatility, due to its significant role in many financial decisions. Ghufran et al. (2016) documented that there were continuous discussions among the market experts and academicians about the causes of volatility in the stock market, as it is considered an obstacle against economic growth, especially in emerging economies where high volatility leads to capital erosion. Cai et al. (2017) asserted this when stating that a large body of financial studies exists on the stock market volatility because it is crucial to many issues in finance, including risk management, asset pricing, and asset allocation. Some of these previous studies introduced various factors as possible causes of stock market volatility, such as dividend policy (Rashid & Rahman, 2008), firm special characteristics (Profilet & Bacon, 2013), trading volume (Al-Habashneh et al., 2015), political situation and investor's behavioral factors (Ghufran et al., 2016), and the economic variables (Cai et al., 2017).

Capital allocation in stock markets are affected by different variables, among them is investor behavior, which is related to the market prices of stocks. And because investors' resources are limited, they try to use them conservatively, by choosing the best alternative for investment, so they rely heavily on the accounting information in general and on income information in particular to rationalize the decisions of buying, holding, and selling stocks. Nafea, Vakilifard, and Fatholahi (2013) and Obaidat (2016) concluded that investors rely mainly on the accounting information, especially income figures for making rational decisions. So, it can be argued that there is a link between the income numbers and the stock price, as investor behavior is affected by the income numbers and investor behavior affects the stock price.

There is a general consensus among accounting academicians and firms' managements regarding the relation between past income patterns and stocks prices. Linda (2013) argued that if information uncertainty is reduced by income smoothing and investors are rational, then the stocks of smoothers should be priced with a premium. In the same context, Nafea, Vakilifard, and Fatholahi (2013) found that investors favor firms with smoother income because they believe that fixed income rather than varying one can guarantee higher dividends.

Welc (2014) concluded that investors tend to appreciate firms with high income smoothness and avoid firms with instable income because they treat past income smoothness as a proxy for the expected investment risk and as a proxy for predicting future income, which gives firms managers the motivation to "cook the books" to report smoother income. Harnovinsah and Indriani (2015) concluded that firms' managements engage in income smoothing actions to reduce the variability of reported income in order to reduce the risk of the stock, which in turn positively influences the stock market price.

This study aimed to investigate the association between income smoothing practices and stock market price volatility; in addition it aimed to investigate if the variables of firm sector, size, profitability, financial leverage and trading volume affect this association for the non-financial firms listed on ASE for the period extending from the beginning of 2011 until the early of 2017 (the time of conducting this study). Eckel's (1981) and GARCH models were used to measure income smoothing and stock price volatility respectively. Results indicated the nonexistence of any significant effect of income smoothing on stock market price volatility. Results also indicating that larger firms are more profitable, more attractive to investors and have less volatile stock price than smaller ones.

This study investigates the relationship between income smoothing and stock market price volatility of non-financial firms listed on Amman Stock Exchange (ASE) for the period extending from 2011 to 2017. The results indicated that there is no significant effect of income smoothing on stock market price volatility. The results also indicated that firm size was the only variable significantly associated with volatility, where larger firms have less volatile stock price than smaller ones.

LITERATURE REVIEW

Lev and Kunitzky (1974) study was one of the first studies, according to the researcher's knowledge, that amid to draw attention to the association between smoothing and the stock market price volatility. Lev and Kunitzky (1974) investigated the association between the extent of smoothing a set of financial statement measures (sales, production, capital expenditures, dividends, and earnings) and overall and systematic common stock risk. The study revealed a significant association between smoothing these measures and volatility. Pastor and Pietro (2003) study revealed that profitability volatility related positively with idiosyncratic return volatility. Rashid & Rahman (2008) examined the relationship between dividend policy and stock price volatility, and found that there is an evidence of positive, but not significant, relationship between stock price volatility and dividend yield, where the stock price reaction to the earnings announcement differs between developed and developing countries. Sabri (2008) investigated the impact of changes in trade volume on the volatility of stock prices in some stock markets in the Middle East, concluding that the highest correlation between trading volume and stock price movement was found in the Saudi stock market, Amman stock market, Muscat stock market, and Kuwait stock market respectively.

Using a sample of 118,000 firm-year observations over a 50 year period, Noguer and Markarian (2012) investigated if discretionary income smoothing affects stock idiosyncratic volatility. The results indicated a negative association between income smoothing and stock price volatility on average, but when the income smoothing reduces information quality, it is associated with higher stock price volatility, suggesting that investors may exhibit different reactions when they are more sophisticated. Profilet and Bacon (2013) investigated some factors that lead a stock to be more volatile, and found that the firm size and dividend yield were the most factors negatively associated with stock price volatility. Linda (2013) concluded that income smoothing through both total accruals and discretionary accruals reduced firms' information uncertainty measured by stock price volatility.

Nafea, Vakilifard, and Fathollahi (2013) study assessed whether firms listed on Tehran stock exchange market smooth their...