Investment opportunity and anticipatory smoothing in corporate enterprises in India

Abstract

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 the basis of their performance in terms of profit generation [profit 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 specifically used in studying the relationship between IOS and income smoothing. Specifically, we use three variables to construct an index of the IOS of each firm, 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 confirmed 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 confined to only 12 profit-making corporate enterprises in the private sector in India, leaving all other enterprises. Though these companies constitute a significant 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 firm are potential indicative of a firm’s income smoothing behaviour. The findings of this study are 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-defined 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-flow view of earnings. The findings 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.

Citation

Goel, S. (2016), "Investment opportunity and anticipatory smoothing in corporate enterprises in India", Journal of Financial Crime, Vol. 23 No. 3, pp. 655-670. https://doi.org/10.1108/JFC-09-2015-0048