The effect of profit smoothing on profit quality and market pricing under environmental uncertainty

Academic Thesis for Master's Degree Field: Business Management Major: Financial Management

Abstract

The purpose of this research is to examine the relationship between profit smoothing and stock returns in conditions of environmental uncertainty. Also, in this research, the stability of profits of companies that have smoothed profits in the past has been investigated in conditions of environmental uncertainty. In this research, the profit smoothing index has been measured for 74 sample companies. Then, using the Tucker and Zarvin model, the relationship between profits and current returns has been investigated by entering the environmental uncertainty index in the model for the years 2015-2015. The results of the research showed that with the increase in environmental uncertainty, the relationship between stock returns and profit smoothing does not become stronger, and the stability of profits of companies that have smoothed profits in the past is not greater under conditions of environmental uncertainty. Key words: profit smoothing, profit stability, environmental uncertainty. Accountants emphasized profit measurement and financial analysts also want to publish it (Hendrickson and Michel, 1992). Profit smoothing is the effort of the management of the business unit to reduce abnormal fluctuations, as far as the reasonable and rational principles of accounting and management allow (Biddle and Karl, 1973). Many investors prefer to invest in companies that have a constant trend of profitability (Tucker Vazarvin, 2006).

Research by Mitchelson et al. (1998) shows that profit smoothing affects the future returns of companies' shares and the market responds positively to smooth profits. Stock returns alone have informational content for shareholders and are used to evaluate performance. One of the factors that can change the correlation between profit smoothing and current stock returns is environmental uncertainty, which is the main basis of this research. Environmental uncertainty is a change in the phenomena surrounding the organization, which consists of factors such as the government, competitors, technology, supply and demand of labor force, customers and clients, which causes a kind of inability to predict the possible results of a decision. (Habib et al., 2011).

The profit is more stable if it is not caused by unusual and unexpected events. In other words, the sustainability and repeatability of profit is defined as profit stability. Financial analysts and investors do not pay attention to the accounting profit figure as the only determining indicator in determining future cash flows, but for them, the sustainability of profit and the repeatability of the reported profit are very important (Nazimi and Khajovi, 2014). Tai came to the conclusion in his research that the stability of profits of companies that have smoothed in the past is low. Therefore, this research seeks to determine what the stability of profits is in companies that have smoothed profits in the past under conditions of environmental uncertainty. 1-2 statement of the research problem One of the key elements in decision-making is the financial statements of companies, especially the profit statement, which represents the results of the business unit's operations in a financial period, the final figure of which is considered as the basis for most decisions, valuation models and stock pricing. In such a way that its accuracy, precision, accuracy, reliability, reliability, predictability and realization will have a direct relationship with the accuracy of decisions and evaluations. Since the responsibility of preparing financial statements is the responsibility of the management of the business unit and due to the direct access of the managers of the business units to the information and having the right to choose optional accounting methods, there is the possibility of profit management. Profitability management threatens the use of profit as a decision criterion (Richardson and Elson, 2001). Purposeful intervention in the process of financial reporting outside the institution with the aim of obtaining personal profit is called profit management (Skipper, 1999). One of the aspects of profit management is profit smoothing which is considered in this research. Profit smoothing is a voluntary and conscious action by managers to reduce profit fluctuations by using personal tools. Mitchelson et al.'s research (1998) shows that profit smoothing has an effect on the stock returns of companies and the market responds positively to smooth profits.Mitchelson et al.'s research (1998) shows that profit smoothing has an effect on companies' stock returns and the market responds positively to smooth profits. Certainly, the existence of a company with stability and less risk can be attractive for risk-averse investors in turbulent stock markets. By maintaining their reputation as efficient and dynamic companies among competitors, these companies attract the favorable opinion of investors and it becomes easier for them to attract capital.

The twenty-first century will be associated with complex, dynamic and evolving organizations which environmental uncertainty is one of its characteristics. Usually managers adapt themselves to the environment through processes. They implement programs to direct the activities of the organization and influence the behavior of the interested groups and to adapt to the factors that exist indirectly. Therefore, environmental uncertainty creates an incentive for managers to perform profit smoothing and change the profit reported by the organization. Environmental uncertainty causes information asymmetry between directors and shareholders, but managers reduce the resulting information asymmetry by smoothing profits (Habib et al., 2011). Executive directors believe that profit smoothing causes less volatility in the share price and lower risk and more stability. As a result, banks and other lenders lend to these banks with lower interest, as a result, the cost of capital and the cost of debt are reduced (Graham and Harvey, 2005). Environmental uncertainty is a change in the phenomena around the organization, which consists of factors such as the government, competitors, technology, labor supply and demand, customers and clients (Habib et al., 2011).

Also, in this research, one of the most important features of profit quality, namely profit stability, will be considered. Sustainable profit is a profit that is not caused by unusual and unexpected activities (Kordestani and Majdi, 2018). It seems that due to the uncontrollable nature of the forces that make up the business environment, the interdependence between these forces, the dynamism and complexity of the business environment. It is difficult to maintain a stable trend for the company's profit over time.

The current research seeks to answer the question, does profit smoothing have an effect on abnormal stock returns under environmental uncertainty? Is the profit stability of companies that have smoothed profits in the past more under the conditions of environmental uncertainty? 1-3 Necessity and importance of research The reason for choosing this topic is the importance of recognizing environmental uncertainty and the high environmental volatility in our country. It seems that in our country, environmental factors have an effect on the stock returns of companies. Also, knowing the factors affecting stock returns in the long-term growth and economic health will leave a positive impact. Considering the effects of the global financial crisis on Iran's capital markets and the economic statistics obtained from the results of the last 15 years, it indicates a business environment with high uncertainty. Therefore, it is necessary to carry out a research to determine the impact of accounting concepts such as profit smoothing in the capital market.

In the conditions of relative environmental stability, managers seek to use tools so that they can predict the future with them. But in many cases, managers become a kind of simplistic towards the uncertainty and turbulence of the environment. This neglect itself can increase the level of uncertainty. The way managers perceive uncertainty and environmental turbulence and their mental map can be different depending on the type of culture and geographical region, the nature of the industry and the requirements of time.

1-4 Research Objectives

The main and general purpose of this research is to examine the relationship between profit smoothing, profit quality and stock returns in conditions of environmental uncertainty, and to achieve this goal, the following sub-objectives have been developed:

1 Investigating the reaction of the stock market against the profit smoothing of companies that They operate in an environment with high uncertainty.

2 Examining the relationship between profit smoothing and stock returns under conditions of environmental uncertainty.

1- 5 research hypotheses:

First hypothesis: with the increase of environmental uncertainty, the relationship between profit smoothing and stock returns becomes stronger.

Second hypothesis: profit stability in companies that have used more profit smoothing in the past is more under conditions of environmental uncertainty.

1- 6 research methods:

The present research is applied in terms of purpose and in terms of its nature in the field of descriptive-cause-and-effect research because the researcher describes and interprets what is. The research method is reference and library.