THE ROLE OF INCOME SMOOTHING ON
FINANCIAL PERFORMANCE INDICATORS
Karzan Adnan Khzer*
Accounting Department – College of Administration & Economic – University of
Sulaimani – Iraq
karzan.khzer@univsul.edu.iq
Dr. Rizgar Abdullah Sabir Jaf
Accounting Department – Salahaddin University – Erbil / Iraq
rizgar.sabir@su.edu.krd
Reception: 18/03/2023 Acceptance: 18/05/2023 Publication: 08/07/2023
Suggested citation:
Khzer, K.A. and Sabir Jaf, R.A. (2023). The Role of Income Smoothing on
Financial Performance Indicators. 3C Empresa. Investigación y
pensamiento crítico, 12(2), 362-376.
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ABSTRACT
The primary objective of this study is to determine whether income smoothing
procedures have an impact on the financial performance of return on assets (ROA)
and return on equity (ROE). Data for this study came from a sample of banks that are
listed on the Iraq Stock Exchange. The research sample consists of banks listed
between 2015 and 2019 on the Iraq Stock Exchange. The model estimate is done
using the panel data approach. Five banks match the required requirements, and the
samples were chosen using a purposive sampling technique. This study employs
Miller's model to distinguish between banks that used income smoothing and banks
that did not, as well as certain statistical techniques to examine the data. Two indices
of financial performance—return on assets (ROA) and return on equity (ROE). Were
used to compare the performance of smooth and non-smooth income banks and the
variations in the influencing variables that influence each. The findings of this study
demonstrate that return on assets (ROA) and return on equity (ROE) have a
considerable impact on income smoothing procedures, while variable volume has a
significant positive impact as well. In this study, we observed statistically significant
differences between banks with and without smooth income in terms of their returns
on assets (ROA) and returns on equity (ROE). We found a statistically significant
positive relationship between bank size, financial success, and income smoothing in
our study.
KEYWORDS
Income smoothing, financial performance, Banking sector, Miller's model, and
emerging economy.
INDEX
ABSTRACT
KEYWORDS
1. INTRODUCTION
2. LITERATURE REVIEW
2.1. Income smoothing
2.2. Financial performance
3. HYPOTHESIS DEVELOPMENT
4. METHODOLOGY
4.1. Population and Sample
4.2. Define operational variables
5. DATA ANALYSIS AND DISCUSSION
5.1. Descriptive Statistics
5.2. Hypotheses Testing
6. CONCLUSION
REFERENCES
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1. INTRODUCTION
Income smoothing is a type of earnings management that management use across
several periods to display a constant level of profit flow. To attain the level of earnings
anticipated by the market or analyst, management may often employ income
smoothing to lessen earnings volatility over a given time [1] By setting aside a portion
of income during prosperous times and increasing reported income during periods
when it falls short of expectations, the volatility of income can be reduced. Several
factors might affect a company's income-smoothing procedures. Profitability is one of
the key elements that affect income smoothing. A company's profitability, which is a
gauge of its level of managerial effectiveness, is its capacity to make profits over a
period [2]
Income smoothing is frequently impacted by a number of factors, including financial
performance. This practice is a typical method of managing profits. The managers
implement the income smoothing approach, which involves boosting or reducing
reported income to reduce its volatility. Creating reserves or earnings from the
unreported amounts of earnings in good years to cover the low financial performance
years is the procedure of income smoothing. The smooth revenue the company
reports in its financial statements for each period is a sign of a strong corporation, and
investors and management favor this characteristic since it demonstrates the firm's
strong performance [3]. One of the elements that motivate behavior income smoothing
is financial performance. This practice is a common technique for managing profits.
The managers use an income smoothing approach that involves changing the
reported income either increasing or recreating to reduce its volatility. The creation of
reserves or profits from unreported earnings in strong years to offset the low financial
performance years is the practice of income smoothing.
Smooth revenue in the financial statements for every period is a sign of a strong
company, and investors and management favor this feature since it indicates strong
company performance [3]. Management is responsible for creating the financial
statements. As a result, agency theory claims that management knows more about
the firm than the firm owner. So, managers have the freedom to take a variety of
alternative measures to adjust different accounting procedures in a way that serves
the interests of the business. This is what motivates managers to undertake income
smoothing, whether they realize it or not [4]. To satisfy the interests of the firm owner
or the manager of the firm itself, management activities to smooth out income are
typically based on this. Managers use income smoothing to minimize the tax burden
paid and/or raise stock prices or company value to satisfy the interests of business
owners. while satisfying the requirements of management itself, meaning getting
payment or keeping his job [5]. By examining income smoothing practices as one of
the forms of management intervention in the accounting measurement and disclosure
process and their impact on the financial performance indicators of banks, the findings
of this study add to the body of knowledge about firms' income-smoothing behavior.
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As well as the significance of researching the techniques employed by
management for income smoothing practices and their effect on enhancing the
financial performance of banks, as well as the significance of employing the (Miller
model) in identifying and diagnosing income smoothing practices.
The purpose of this study is to investigate the connection between financial
success and income-smoothing strategies. This paper's main goal is to demonstrate
how, in the context of earnings management, income smoothing procedures have an
impact on the significance of earnings value and financial performance. On these
topics, a prior study has been conducted. Yet, other studies have shown contradictory
findings. The goal of this study is to increase the accuracy of achieving the best
reflective outcome by evaluating a model for income smoothing screening techniques.
This paper is organized as follows: the next section is followed by a discussion of
reviews of the literature to develop the research hypotheses. Next, the research
method and data-collecting process are described, followed by a discussion of the
empirical results. The paper ends with a conclusion.
2. LITERATURE REVIEW
2.1. INCOME SMOOTHING
According to agency theory, a firm is a legal agreement between the party in
charge of managing a resource and the owner of the resource. When the principal
assigns the agent to action and gives them the power to make decisions, an agency
relationship may develop. [6]. in a relationship based on agency, the principal expects
the agent to represent his interests. The main objective of the agent's activities,
regulations, and tactical decisions is to maximize his welfare. Agents, on the other
hand, might work against the interests of the principal since they have their interests.
According to agency theory, management, and principals' competing interests have an
impact on how earnings are managed. By relocating employees, managers may
enhance their well-being. It's possible for managers to want to artificially boost
company performance. The manager's position will rise through expanding the
business, accelerating its growth, or improving performance. The objective is to
strengthen employment security from the possibility of dismissal and secure jobs,
bonuses, and pay increases [7].
The goals of management activities for income smoothing often revolve around
advancing the interests of the business's manager or owner. Managers smooth out
profits to lower tax liabilities and/or boost stock prices or company value to fulfill the
objectives of business owners. However, to keep his job or fulfill the needs of
management itself, such as receiving a salary [5]. By replacing the revenue from a
poor year with that from a good year, income smoothing attempts to equalize the
swings in income that are associated with particular years. Similarly to this, moving
losses or spending from time to time can alter income volatility. For instance, a
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corporation may lower discretionary costs in a given year to boost current profitability
but do so at the risk of raising discretionary costs in the next year [8]
The accounting and finance literature has been interested in the topic of income
smoothing for many years. Most studies viewed income smoothing as "immoral" due
to the "cheating" and "misleading" that went on because it was done by any firm's
management. [9]. Proponents claim that one of the incentive accounting practices
known as "income smoothing" is modifying and manipulating swings in a company's
earnings at specific high points. There are two feelings that apply to the management
of earnings. The first is more prevalent and rejects income management, but in the
second case, stakeholders define such actions as management according to their
preferences [10]. Actions to smooth out income are typically taken for a variety of
reasons, such as lowering taxes or avoiding pressure from employees to raise
salaries or pay. To draw in investors, creditors, and other outside parties, company
management might also take steps to obtain the desired profit position in the income
statement. This is due to the dysfunctional behavior of income smoothing, which
seeks to increase investors' perceptions of the company's worth [11]
2.2. FINANCIAL PERFORMANCE
A financial ratio is a technique used to describe the connection between two types
of financial data in mathematical terms. According to [12], the purpose of performance
measurement is to compare business performance and management to the
company's goal or target. It is also true that a company's financial standing may affect
how well it operates. As a result, financial statements are crucial diagnostic tools for
knowledge management. A company's financial position and operating results are
stated in its financial statement at a specific period of time. According to research
done by [13], firms with a habit of achieving past period earnings are more likely to
engage in income-smoothing earning management methods, and as a result, earning
management practices are highly correlated with company success. that there is a link
directly connecting earnings management to business performance [14].
Also, it found that there is a substantial inverse association between the degree of
earnings management and the performance indicators for firms [15]. As a result, the
literature study offers enough proof that there is a considerable connection between
effective earnings management techniques and company success. The financial
performance focuses on factors directly related to financial reports and includes a
variety of measures, but financial leverage and profitability ratios, such as return on
assets (ROA) and return on equity, are beneficial for investors to invest in the capital
market and minimize high tax payments (ROE), The two ratios that will be utilized in
this study and connected to the examination of the financial statements of the
performance of the firm are:
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Return on Asset (ROA)
The capacity of the firm to turn a profit from sales, total assets, and own capital is
known as profitability. Users of financial statements should be highly familiar with
profitability ratios since they provide information about a firm's potential to create
profits. A higher profitability ratio indicates better management of the organization [16].
When the return on asset (ROA) is positive, it may be used to determine if the firm
can make money from the total assets utilized in operations [17]. If the return on
assets (ROA) is negative, it might indicate that the company's activities do not
generate a profit (loss) [18].
Return on Equity (ROE)
According to [19] .ROE evaluates the company's shareholders' returns, including
both preferred and common stockholders. ROE has evolved into one of the factors
that investors use to assess a company's stock price since it directly affects a
company's intrinsic worth [20]. If a corporation has no debt, both its ROA and ROE will
be equal. There is a similarity between ROA and ROE. Yet, ROE will surpass ROA if
the firm has financial leverage [21]. Debt will enhance the company's cash flow and its
asset base [22].
3. HYPOTHESIS DEVELOPMENT
The research supports the presence of managers' incentives to smooth
compensation based on agency theory. Even when it is not in the best interest of
shareholders, the separation of ownership and control encourages managers to
manage earnings to serve their interests [23], [24] and [25] for example, examined the
impact of income smoothing and earnings quality on the financial performance of
pharmaceutical companies quoted on the Nigerian Stock Exchange from 2006 to
2014. The current study focuses on the financial performance and income smoothing
of banks listed on the Iraqi Stock Exchange. The profitability ratio return on assets
(ROA) affects income smoothing. A high profitability ratio is one of the reasons to
undertake income smoothing since it demonstrates the company's capacity to
generate profits in the future, and management might manage the earnings using that
knowledge [26] .This study's primary goal is to investigate how income smoothing
affects the financial performance of banks that are listed on the Iraqi Stock Exchange
with a focus on the relationship between profitability and financial performance. Out of
the three variables studied, two hypotheses may be made based on the theory of
variables and the findings of previous research, and all of the hypotheses are as
follows:
H1:
Income smoothing has a significant impact on the financial performance
indicators, represented by the return on assets (ROA)
H2:
Income smoothing has a significant impact on the financial performance
indicators, represented by the return on equity (ROE)
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4. METHODOLOGY
This study is an example of explanatory research, which uses hypothesis testing to
explain the causal link between variables. Identify cause-and-effect correlations
between the variables by designing this research. Secondary data is what was used.
The study's data are from the Bank of Iraq's 2015–2019 financial report statistics.
4.1. POPULATION AND SAMPLE
All commercial banks registered on the Iraqi Stock Exchange between 2015 and
2019 make up the study's population. Purposive sampling, which has regularly
resulted in published audited financial accounts, is used to collect samples.
Quantitative data and secondary data, specifically data in the form of figures obtained
from observation data on financial ratios from financial statements collected from
various points in time and data collected from those registered with the Iraq Stock
Exchange in the years 2015 to 2020, are the types and data sources used in this
research.
4.2. DEFINE OPERATIONAL VARIABLES
Income smoothing is the independent variable in this research. Several studies
describe the models used to measure income smoothing practices, [27] and [28] but
for this study, we picked the Miller model since it is the most recent model for doing
so, is simple to use, and can easily be obtained the data needed to utilize it. to assess
income-smoothing techniques. Miller (2007) introduced the ratio of the relationship
between the change in working capital as an element subject to manipulation and the
cash flow from operating activities as an element not subject to manipulation because
current assets and liabilities are the constituent elements of working capital (current
assets - current liabilities).
The dependent variable is a variable that will be tested for the effect on the
independent variable. In this research, the dependent variables used are ROA (Y1)
and ROE (Y2) Below are the measurements of the variables. Table 1 presents the
measurement of the used variables .
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Table 1. Variable Measurement
5. DATA ANALYSIS AND DISCUSSION
This study examined the impact of income smoothing practices on bank financial
performance (ROA) and (ROE) in the period 2015-2019.
Table 2. Apply Miller's model to the study sample banks
Variables
Measurement
Income smoothing (X)
So-called the Miller Ratio, it can be used to detect manipulation of profits,
as its value is zero in the absence of manipulation. If the Miller ratio differs
from zero (negative or positive), this is an indication of the existence of
manipulation in the profit number. Prepared according to the accrual basis.
(∆WC / CFO) t-o – (∆WC / CFO) t-1 = 0
CA: denotes current assets,
CL: denotes current liabilities
WC∆: denotes the change in net working capital,
CFO: Refers to cash flow from operating activities.
ROA (Y1)
ROA is a tool for measuring a company's ability to earn profits through total
asset management. The formula is net income divided by total assets [22]
ROE (Y2)
ROE is generally one of the most important variables in determining what
level of capital is due. The formula is net income divided by equity.
Banks
fiscal year
(∆WC / CFO) t-o – (∆WC / CFO) t-1 =0
Kurdistan
2015 0
2016
20.782
2017
-21.149
2018 -21.149
2019
-3
Cihan
2015
0
2016 284
2017
-2.743
2018
2.825
2019 -1.375
Erbil
2015
0
2016
453
2017 0.02
2018
-363
2019
-2.05
Mosul
2015 0
2016
8
2017
-3.151
2018 4.494
2019
3.762
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follows:
Table 3. Financial performance ratios of the study sample banks
Which reflects the variation in this rate during the study period.
Banks
fiscal year
ROA (Y1)
ROE (Y2)
Kurdistan
2016 8 13
2017
38
68
2018 5 11
2019 1 0.0003
Cihan
2016
32
68
2017
26
51
2018 0.0006 14
2019
0.0007
1
Erbil
2016
16
31
2017 13 23
2018
4
14
2019
-7
-14
Mosul
2016 8 13
2017
10
18
2018
6
9
2019 8 12
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It reached (ROA) for Cihan Bank, it was the highest return achieved in 2016, and it
was the lowest return in 2018, and the amount of return ranged between these two
years for the rest of the years, which means the variation of this rate for this bank
during the period and the relatively high risk. And that (ROE) the second dependent
variable of Cihan Bank reached and was the highest return achieved in 2016, as it
was the lowest return in 2019, and the amount of return ranged between these two
years for the rest of the years, which means the variation of this rate for this bank
during the period and the relatively high risk. Which reflects the variation in this rate
during the study period.
The (ROA) for Erbil Bank has the highest return achieved in 2016, as it was the
lowest return in 2019, and the amount of return ranged between these two years for
the rest of the years, which means the variation of this rate for this bank during the
period and the relatively high risk, and the (ROE) was the second dependent variable
for the bank in Erbil. It reached the highest return achieved in 2016, as it was the
lowest return in 2019, and the amount of return ranged between these two years for
the rest of the years, which means the variation of this rate for this bank during the
period and the relatively high risk. Which reflects the variation in this rate during the
study period.
The (ROA) for the Mosul Bank had the highest return achieved in 2018, as it was
the lowest return in 2019, and the amount of return ranged between these two years
for the rest of the years, which means the variation of this rate for this bank during the
period and the relatively high risk. Also, (ROE), the second dependent variable of the
Mosul Bank, has the highest return achieved in 2016, and it was the lowest return in
2019, and the amount of return ranged between these two years for the rest of the
years, which means the variation of this rate for this bank during the period and the
relatively high risk. Which reflects the variation in this rate during the study period.
5.1. DESCRIPTIVE STATISTICS
Table No. (4) shows the general average of the independent variable income
smoothing (X), which amounted to (-1.2097) with a negative value, which means that
the majority of banks have income reduction practices for tax evasion, and the highest
value was (20.78) in the Bank of Kurdistan in 2016, as well The lowest value was
(-21.15) in the Bank of Kurdistan in 2017, and the standard deviation was (9.5545)
and the coefficient of variation was (91.289), and this indicates that the values of the
variables in the study sample were clear.
Table 4. Analysis of variables for the study sample
N
Minimum
Maximum
Mean
Std.
Deviation
Variance
91.289 9.5545 -1.2097 20.78 -21.15 16 Income
Smoothing
-.01
.04
.0106
.01210
.000
16
ROA Y1
-.01
.07
.0208
68
-14
16
ROE Y2
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The first dependent variable (Y1), which represents the rate of return on assets
(ROA), was the general average at the level of the sample banks amounted to
(0.0106), and the highest value was (0.01210) in Erbil Bank in 2016, which means
that this indicator has recorded a decline during the study period. While it was the
lowest value in the Bank of Erbil in 2019 and the standard deviation was (0.04) and
the coefficient of variation was (-0.01), which increased the variance of this indicator
and this confirms the high-income smoothing.
Also, the second dependent variable (Y2), which represents the rate of return on
equity (ROE), was the general average at the level of the sample banks amounted to
(0.0208), and the highest value was (0.068) in the Kurdistan Bank in 2017 and Cihan
Bank in (2016). This means that this indicator has recorded a decline during the study
period. While the lowest value was (-0.014) in the Bank of Erbil in 2019, the standard
deviation was (0.07), and the coefficient of variation was (-0.01), which increased the
variation in this indicator, and this confirms the high smoothing of income.
5.2. HYPOTHESES TESTING
Table No. (5) Shows the effect of the independent variable (income smoothing
practices) on the dependent variables (financial performance indicators) through the
following:
Table 5. Results of regression analysis
The dependent variable ROA: The slope of the correlation coefficient (R) is (0.50)
and the coefficient (R2) reached (3.83), which means that (4%) of the change in return
on assets was caused by the variable income smoothing practices during the
research period. The calculated (t test) value of (** 0.002) is supported, which means
that the relationship is significant in the model at a confidence level of (0.002). The
values of (B), which was (0.704), the value of the slope value in the model as in Table
No. (5), and this project came in the first example, and this project was in the
preliminary work. On this basis, the hypothesis was accepted, which states that there
is a statistically significant effect of smoothing income on the return on assets in the
study sample.
The dependent variable ROE: as the correlation coefficient (R) reached (0.55) and
the coefficient of determination (R2) reached (4.27), which means that (4%) of the
change in return on equity was caused by the independent variable income smoothing
practices during the period The research supports the calculated (t test) value of
Variables
Dependent Variable ROA (Y1)
RR2T test B A SIG
Income smoothing (X)
2
14.7
704
2
3.83
0.50
Dependent Variable ROE (Y2)
Income smoothing (X)
1
18.24
741
1
4.27
0.55
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(0.001), which means that the relationship is significant in the model at a confidence
level of (0.001). As for the values of (B), which were (0.741), it may indicate that the
change in the independent variable (income smoothing practices) by one unit is
reflected by the amount of these values on the return on equity. This means the
amount of slope in the model as in Table No. (5). The value of (A), which amounted to
(18.24), refers to the value of the dependent variable when the value of the
independent variable is equal to zero. This effect came in line with the propositions of
applying income smoothing practices and their impact on the return on equity. On this
basis, the first hypothesis was accepted, which states that “there is a statistically
significant effect of smoothing the income on the return on equity in the study sample
banks”.
6. CONCLUSION
This study aims to investigate how income smoothing methods affect financial
performance measures and how income smoothing functions as a mediator between
these indicators in Iraqi public banks. It has been demonstrated that income
smoothing improves the quality of wages. The quality of financial reports and earnings
reports can be raised by income smoothing. The report's quality increases with
decreasing income volatility. The study's findings revealed that revenue smoothing
procedures exist in the banks that made up the study sample, and their origin may be
traced to the conflicting interests of the parties to the agency represented by
management and shareholders.
The management and stockholders are the parties to the agency that are
represented. From the values of the standard deviation, the coefficient of difference,
the maximum value, and the lowest value, it became clear from the analysis that there
is a disparity in the values of the independent and dependent variables. The study's
findings demonstrate that the income smoothing practices variable has a significant
and statistically significant impact on the dependent variables (indicators of financial
ratios) which the (T-test) value has demonstrated.
Profitability is a crucial indicator of a bank's health and has the power to sway the
choices of investors. As the informational value of returns on assets controlled by
banks is crucial to luring investors to invest in banks, the test results reveal a
substantial positive trend, indicating that management would struggle to manage
profits amid the deteriorating profitability of banks. This will increase the motivation for
banks with lower levels of profitability to level out their income, and consistent revenue
values can also satisfy a bank's top management.
The study's limits on the availability of data between 2015 and 2019 have led to a
decrease in the sample's number of banks. When doing comparable research on Iraqi
commercial banks, more pertinent data can be found by expanding the sample size by
including more banks. Although the Iraqi Stock Exchange produced a decent
summary report, one of the drawbacks of this study is the lack and incompleteness of
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information connected to the financial reports of the various business units. This may
limit subsequent investigation in greater depth on income smoothing for enterprises in
other industries.
Factors analyzed and years will be enhanced to allow a realistic picture of income
smoothing on the Private Commercial Banks. Other financial ratios may be employed
in future publications to analyze the variables influencing income smoothing. Hence,
the performance of each type of business can be analyzed in more depth. For
instance, various financial ratios other than (ROA) and (ROE).
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