Investment opportunity and anticipatory smoothing in corporate enterprises in India

Author:Sandeep Goel
Position:Department of Finance, Management Development Institute, Gurgaon, India
Pages:655-670
SUMMARY

Purpose Income smoothing is exercised by the management for numerous reasons. Growth opportunities available to a firm are a very important reason but an undermined area for income smoothing by the management. This paper aims to review the income smoothing practices in corporate enterprises in India with respect to growth pattern of a firm as measured by investment opportunity set (IOS) defined in Fudenberg and Tirole’s (1995) model. In India, the main corporate ownership model is promoter dominated shareholders model. This makes the study unique highlighting the role of board for income smoothing. The study contributes by extending this model to earnings per share definition with IOS by a firm. The study also investigates the level of income smoothing and its impact on the informativeness of earnings in regard to IOS. Design/methodology/approach The enterprises have been chosen on... (see full summary)

 
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Investment opportunity and
anticipatory smoothing in
corporate enterprises in India
Sandeep Goel
Department of Finance, Management Development Institute,
Gurgaon, India
Abstract
Purpose Income smoothing is exercised by the management for numerous reasons. Growth
opportunities available to a rm are a very important reason but an undermined area for income
smoothing by the management. This paper aims to review the income smoothing practices in corporate
enterprises in India with respect to growth pattern of a rm as measured by investment opportunity set
(IOS) dened in Fudenberg and Tirole’s (1995) model. In India, the main corporate ownership model is
promoter dominated shareholders model. This makes the study unique highlighting the role of board
for income smoothing. The study contributes by extending this model to earnings per share denition
with IOS by a rm. The study also investigates the level of income smoothing and its impact on the
informativeness of earnings in regard to IOS.
Design/methodology/approach The enterprises have been chosen on the basis of their
performance in terms of prot generation [prot after tax (PAT) performance] for the year 2007-2008 as
per Economic Times October 2007 Survey in a private sector. The period to be covered is from 2003-2004
to 2007-2008. 2007-2008 has been a year of global recession which is an indicative reason for income
smoothing by the corporate. DeAngelo model has been used for calculating discretionary accruals and
detecting income smoothing. Fudenberg and Tirole’s (1995) model has been specically used in
studying the relationship between IOS and income smoothing. Specically, we use three variables to
construct an index of the IOS of each rm, market-to-book assets, market-to-book equity and the
earnings price ratio.
Findings – An examination of the units shows that there is smoothing behaviour exercised by them.
Analytical results of anticipatory smoothing and the IOS propose that concern about job security
creates an incentive for managers to smooth earnings in consideration of both current and future
relative performance. More explicitly, the extent of smoothing is expected to be negatively related to the
level of IOS in periods of low current/high future performance and positively related to the level of IOS
in periods of high current/low future performance. The empirical results conrmed our predictions.
Research limitations/implications – The sampling requirements were met by 12 units only of top
25 units, taken for the study. So, the present study was conned to only 12 prot-making corporate
enterprises in the private sector in India, leaving all other enterprises. Though these companies
constitute a signicant size of Bombay Stock Exchange’s market capitalization for completeness of
data, still the size can be extended for further study. The present study has not considered public sector
units and closely held companies. The scope of the units can be extended to other units in diverse sectors
with different size and scale of operations. It would further verify the present discussion and also
provide future enlightenment on the issue of income smoothing. The magnitude of discretionary
accruals has been analysed in regard to potential earnings management. But, discretionary accruals are
not directly available. They are calculated as a proxy using a model. Estimating discretionary accruals
is still a tedious task.
Practical implications – The results clearly indicate that growth opportunities available to a rm
are potential indicative of a rm’s income smoothing behaviour. The ndings of this study are
The current issue and full text archive of this journal is available on Emerald Insight at:
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Investment
opportunity
655
Journalof Financial Crime
Vol.23 No. 3, 2016
pp.655-670
©Emerald Group Publishing Limited
1359-0790
DOI 10.1108/JFC-09-2015-0048
important to standard setters and regulators, as it highlights the need for an effective regulation for
detecting income smoothing. There is a strong need to have well-dened policies and regulatory
mechanism with respect to prevent and detect income manipulation practices at an early stage.
Standard-setting bodies can consider the attributes of assets and liabilities and changes in them also
with the fundamental process of measurement of income. In short, the evidence argues for a revenue/
expense and asset/liability view of earnings, rather than the cash-ow view of earnings. The ndings of
this study are important to policymakers and other stakeholders, as it highlights the need for an
effective board in discharging their role qualitatively, rather than quantitatively.
Social implications – It brings out the importance of fair accounting for shareholders.
Originality/value – It is an original paper which highlights the income smoothing behaviour in
Indian corporate enterprises in terms of growth opportunities available to them.
Keywords Performance, Growth, Discretionary accruals, Income smoothing,
Investment opportunity set
Paper type Research paper
1. Introduction
Income smoothing is a form of earnings management and is generally dened as the
dampening of uctuations in reported earnings over time (Ronen and Yaari 2008, p. 317).
In other words, management is inclined to take actions to increase earnings when
earnings are relatively low and to decrease earnings when earnings are relatively high.
The main reason that managers smooth earnings is “maximizing their own wealth”.
Goel’s (2012) study evaluates the implications of discretionary accruals for earnings
management in the Indian corporate enterprises. His analysis indicates that there is
presence of accrual management in the units.
When making discretionary accounting choices managers consider expected future
earnings (Fudenberg and Tirole, 1995, p. 77). Analytical results by Fudenberg and
Tirole (1995) propose that job security concern creates an incentive for managers to
smooth earnings in consideration of both current and future relative performance. There
is a support for this job security and anticipatory income smoothing theory.
Ahmed et al. (2000) provided more direct test to this effect. He hypothesized that the
extent of smoothing would vary directly with managers’ job security concerns as
proxied by the degree of competition in rms’ product markets, product durality and
capital intensity. Their results show that managers of rms in more competitive
industries and durable goods engage to a greater extent in income smoothing.
So, there is a relationship that exists between “investment opportunity set or growth
opportunities” and anticipatory income smoothing by managers.
Managers of rms with lower growth opportunities as measured by the investment
opportunity set (IOS) are likely to have greater job security concerns than managers of other
rms. A greater extent of income smoothing is expected from managers of such rms. So,
when current earnings are “poor” and expected future earnings are “good”, managers of
rms with lower growth opportunities resort to income-increasing accruals and vice versa.
India witnessed two large corporate scams, namely, Satyam and Kingsher in 2009
and 2012, respectively. It not only led to nancial loss for the shareholders but also
disturbed the status quo of the entire nancial system. Incidence of any such scam
questions the effectiveness of governance framework and quality of income. It requires
a change in the regulatory regime. India had its transformation process in the form of
new Companies Act, 2013 after a gap of 57 years since old Companies Act, 1956. This
JFC
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