202 Int. J. Monetary Economics and Finance, Vol. 8, No.

2, 2015

Market reaction on income smoothing in the

Indonesian manufacturing industry

Iwan Setiadi
Faculty of Economics and Business,
Universitas Sebelas Maret,
Jl. Ir. Sutami No. 36A, Kentingan,
Surakarta, 57126, Indonesia
Email: setiadi_0700@yahoo.com

S. Purnamasari
Faculty of Economics,
Universitas Muhammadiyah Tangerang,
Jl. Perintis Kemerdekaan I/33,
Tangerng 15000, Indonesia
Email: sha_purnama12@yahoo.co.id

Erna Setiany*
Faculty of Economics and Business,
Universitas Sebelas Maret,
Jl. Ir. Sutami No. 36A, Kentingan,
Surakarta, 57126, Indonesia
Email: setiany1189@gmail.com
*Corresponding author

Abstract: The capital market reactions are proxied by cumulative abnormal

return (CAR) and stock trading volume (STV) activity, while for the earnings
information the proxy of unexpected earnings was used. This research used
independent samples tests. The result shows that when measured by CAR, the
market does not show any different reaction, but when measured by STV, the
market reactions of the income smoothing group are significantly different
from those of the non-income smoothing group. Then the sample were split
into two group of positive earnings surprise and negative earnings surprise. The
positive earnings surprise group shows no different market reaction when
measured by CAR, but show different market reaction when measured by STV.
The negative earnings surprise group shows no different market reaction when
measured by CAR and STV.

Keywords: income smoothing; unexpected earnings; market reaction;

abnormal return; stock trading volume activity.

Reference to this paper should be made as follows: Setiadi, I., Purnamasari, S.

and Setiany, E. (2015) ‘Market reaction on income smoothing in the Indonesian
manufacturing industry’, Int. J. Monetary Economics and Finance, Vol. 8,
No. 2, pp.202–212.

Copyright © 2015 Inderscience Enterprises Ltd.

 Market reaction on income 203

Biographical notes: Iwan Setiadi is a PhD student in SebelasMaret University,

Indonesia. He was a Lecturer in the Faculty of Economics of Muhammadiyah
Tangerang University, Indonesia. His research interests include financial
accounting, corporate governance and environmental accounting.

S. Purnamasari is a practitioner and alumni of the Faculty of Economics,

Muhammadiyah Tangerang University, Indonesia.

Erna Setiany is a PhD student in SebelasMaret University, Indonesia. She was a

Lecturer in the Faculty of Economics, Muhammadiyah Tangerang University,
Indonesia. Her research interests include financial accounting and corporate
governance.

This paper is a revised and expanded version of a paper entitled ‘Market

reaction of manufacturing firms on income smoothing in the Indonesian
Stock Exchange 2009–2012’ presented at SIBR-RDINRRU 2014 Conference
on Interdisciplinary Business & Economics Research, Hong Kong,
27–28 September, 2014.

1 Background

This research aims to examine how the capital market reacts on income information
provided by income smoothing companies and non-income smoothing companies.
The reaction of the stock market is proxied by the cumulative abnormal return (CAR) and
the stock trading volume (STV), which was tested on income smoothing companies and
non-income smoothing companies as well as a group of companies that show positive
earnings surprise and negative earnings surprise.
Statement of Financial Accounting Concept No. 1 states that information about
earnings is used to assess management performance and to estimate representative
earnings capacity. In addition, the information about earnings is also used to measure the
risk of an investment. Thus, the earnings information in the financial statements is
required by investors in the decision-making process.
Income smoothing according to Beidleman (1973) is defined as an attempt done by
the management to smoothen the variations in the income to the extent allowed
by accounting principles. This can lead to aberrant behaviour, namely earnings
manipulation, i.e., by performing income smoothing. Meanwhile the investors’ attention
is often focused on the income information provided by a company’s income statement
rather than on the procedures that are used by the company to generate the income
information (Beattie et al., 1994).
In the context of earnings smoothing, expected earnings are interpreted as ‘targets’
earnings reported by the management instead of the earnings expected by the market
(Beattie et al., 1994). The management reduces fluctuations in reported earnings to
conform with a desired target, so that the profit generated is expected to look attractive,
which can facilitate investors to predict future earnings (Koch, 1981).
Similar studies that took place in the Indonesian market, among others, are Assih and
Gudono (2000), Juniar et al. (2007) and Restuningdiah (2010), who proved that there are
differences in the capital market reaction to income smoothing companies and non-
income smoothing companies. Other studies conducted by Salno and Baridwan (2000),
204 I. Setiadi et al.

Subekti (2005), Aisjah (2005), Agriyanto (2006) and Mudjiono (2010) conclude that
there is no difference in the market reaction to the income smoothing companies and
non-income smoothing companies. Based on the inconsistency of the results of the
previous studies in Indonesia, this study examined whether there is a difference between
the market reaction to income smoothing companies and non-income smoothing
companies? Is there a difference in the market reaction to income smoothing companies
and non-income smoothing companies in the group of companies that show positive
earnings surprise? And is there a difference in the market reaction to income smoothing
companies and non-income smoothing companies in the group of companies that show
negative earnings surprise?

2 Literature review

Ball and Brown (1968) stated that the information contained in the accounting numbers is
useful if the real earnings are different from the earnings expected by an investor. This is
supported by Beaver (1968) who stated that if the annual income announcement contains
information, then the variability of the stock price changes will appear larger when the
income is announced than the other moment during the year, this is owing to a change in
the equilibrium value of stock price during the announcement period. In addition, the
earnings information is considered informative if this information can enhance market
participants’ trading activity.
Beaver (1968) stated also that an announced report is said to have informative content
if the number of shares traded becomes greater when earnings were announced compared
with the other time. So, in this case, the market reacts to information provided by a
company, no matter whether it is positive or negative information.
Several previous studies have found evidence for a variety of reasons why companies
perform the income smoothing. Moses (1987) has found evidence that a bonus plan is
used as the objective of income smoothing. Companies’ reasons in performing income
smoothing, according to Hepworth (1953), are
• as a modification to reduce profits and to raise costs in the current period, which can
reduce tax debts
• as a form of increase in the company image in the eyes of investors
• as a bridge between a company’s management and employees
• has a psychological impact on economy.
The main purpose of earnings reporting is to provide information that is useful for
internal and external parties, while the specific purposes of earnings reporting are as
follows:
• earnings reporting is used as a measurement of management efficiency
• the use of historical earnings numbers helps to predict a company’s future direction
or future dividend payment
• the use of earnings information as a measurement of achievement and as a guideline
for future managerial decision.
 Market reaction on income 205

Cahan et al. (2008) stated that income smoothing is one type of earnings management
actions. The objective is to reduce periodic variation of earnings from time to time.
Schröder (2009) stated that the practice of income smoothing is a common practice that is
done by managers to reduce the fluctuation changes in earnings, which is expected to
have beneficial effects for management performance evaluation. Previous research states
that income smoothing exists mainly because managements prefer to keep their earning
in a stable value instead of keeping their earnings in a volatile value, so that the
management will increase reported earnings if the number of actual earnings is declined
from previous year’s earnings, and conversely the management will choose to lower
reported earnings if the actual earnings are higher than the previous year’s earnings
(Schröder, 2009).
A number of previous studies with the setting in the Indonesian market, e.g., Salno
and Baridwan (2000), Subekti (2005), Aisjah (2005), Agriyanto (2006), Juniar et al.
(2007) and Mudjiono (2010) reveals that the market reaction, which is proxied by
CAR and STV, did not differ between an income smoothing company and non-income
smoothing company.
Based on the description above, the first hypothesis of this study is as follows:
H1: The market reacts significantly different to income smoothing companies and
non-income smoothing companies.
Booth et al. (1996) indicated that non-income smoothing companies have a higher
unexpected return for any earnings surprises compared to income smoothing companies.
Sloan (1996) stated that unexpected earnings have a significant effect on an abnormal
return received by investors. The financial statements are a tool used by investors and
creditors to assess the performance of a company. The announcement of the loss is a
negative signal for investors. To avoid this, the management of a company does income
smoothing (Burgstahler and Dichev, 1997; Burgstahler and Eames, 2006).
In Indonesia, research conducted by Assih and Gudono (2000) Juniar et al. (2007)
proved that, on the group of companies that show positive and negative earnings surprise,
capital market reacts differently to earnings information announcement from companies
that perform income smoothing and non-income smoothing. Aisjah (2005) and Subekti
(2005) proved that market reaction is not significantly different from the companies that
show positive and negative earnings surprise.
Based on the description above, the second hypothesis in this study is as follows:
H2: Market reactions differ significantly between companies that show positive
earnings surprise.
H3: Market reactions differ significantly between companies that show negative
earnings surprise.

3 Sampling method

The population in this study consists of all manufacturing companies in Indonesia during
the observed year. The sample used in this study consists of all basic industry and
chemicals companies listed on the Indonesia Stock Exchange in 2009–2012, which
published their annual report in the respective years. There are 30 companies fulfilling
206 I. Setiadi et al.

the criteria for this research sample, the sample size should be at least 10 times the
variable numbers used in the research (Sekaran and Bougie, 2009).
We used independent sample test to analyse the data. Secondary data have been
obtained from journals, Indonesian Capital Market Directory, www.idx.co.id site and
from the website of each sample company.

4 Research result

The first hypothesis of this study examined whether there is a significant difference of
capital market reaction to income smoothing companies and non-income smoothing
companies. Income smoothing is a proxy for earnings management strategy used by
managers by increasing or decreasing reported earnings to reduce its fluctuation (Wild
and Subramanyam, 2010). An income smoothing index is calculated by dividing the
coefficient of variation in net income changes with the coefficient of the variation in
interest income changes, according to Eckel (1981). Companies that show Eckel index
less than one (EI < 1) are classified as income smoothing companies and if the Eckel
index is more than one (EI > 1) they are classified as non-income smoothing.
Table 1 shows the result of independent samples test on the first hypothesis.

Table 1 All sample companies

Independent samples test

Levene’s test for equality of variances t-test for equality of means
F Sig. T Sig. (2-tailed) Mean difference
CAR 1.380 0.250 0.643 0.525 0.00116
STV 2.117 0.157 2.144 0.041 0.00146**
*, **, *** indicate significant at less than 10%, 5% and 1% level, respectively.
Where,
CAR: cumulative abnormal return of stock number-i in days-t which are calculated from
the beginning of the window period until the end of the window period, within five days
before and after earning anouncement.
STV: Stock trading volume mean.

The F value of CAR on Levene’s test is 1.380 with a significant value of 0.250.
The t value on the independent samples test is 0.643 with a significant value of 0.525,
greater than 0.05, so it can be concluded that the market reaction, which is proxied by
the CAR, does not differ significantly between income smoothing companies and
non-income smoothing companies.
The F value of STV on the Levene’s test is 2.117 with a significant value of 0.157.
The t value on the independent samples test is 2.144 with a significant value of 0.041,
that is less than 0.05, so it can be concluded that the market reaction, which is proxied
by STV, shows a significant difference between income smoothing companies and
non-income smoothing companies.
Tests using CAR as a measure of market reaction show that there is no difference in
the market reaction between income smoothing companies and non-income smoothing
companies. The results of this study support previous researches by Salno and Baridwan
 Market reaction on income 207

(2000), Subekti (2005), Aisjah (2005), Agriyanto (2006) and Mudjiono (2010), which
state that there are no differences in the market reaction that is proxied by the CAR.
Nevertheless, this study contradicts the research conducted by Assih and Gudono (2000),
Juniar et al. (2007) and Restuningdiah (2010), who proved that there is a difference in the
market reaction, which is proxied by CAR, between income smoothing companies and
non-income smoothing companies.
When using STV, the results of this study indicate that there is a difference in the
market reaction between income smoothing companies and non-income smoothing
companies. The results of this study support the research conducted by Assih and Gudono
(2000), Juniar et al. (2007) and Restuningdiah (2010) in Indonesia, which prove
the existence of differences in market reaction, which is proxied by the STV, between
income smoothing companies and non-income smoothing companies.
The second hypothesis proposed in this study is whether there is a difference
in the capital market reaction to income smoothing companies and non-income
smoothing companies in the group of companies that show a positive (negative) earnings
surprise.
The test results in Table 2 show that the F value of CAR on the Levene’s test is 2.710
with a significant value of 0.114, so the significant value is greater than 0.05. The t value
on the independent samples test is 0.834 and has a significant value of 0.413, so it is
greater than 0.05. Therefore it can be concluded that the market reaction, which is
proxied by the CAR, which states that there are no significant differences between
income smoothing companies and non-income smoothing companies in the group of
companies that show positive earnings surprise.

Table 2 For companies that show positive earnings surprise

Independent samples test

Levene’s test for equality of variances t-test for equality of means
F Sig. T Sig. (2-tailed) Mean difference
CAR 2.710 0.114 0.834 0.413 0.00176
STV 1.543 0.227 1.745 0.095 0.00113*
*, **, *** indicate significant at less than 10%, 5% and 1% level, respectively.
Where,
CAR: cumulative abnormal return of stock number-i in days-t which are calculated from
the beginning of the window period until the end of the window period, within five days
before and after earning anouncement.
STV: Stock trading volume mean.

The F value of STV on the Levene’s test is 1.543 with a significant value of 0.227.
The significant value is greater than 0.05. The t value on the independent samples test is
1.745 with a significant value of 0.095 that is less than 0.10, so it can be concluded that
the market reaction, which is proxied by STV, is different significantly between income
smoothing companies and non-income smoothing companies in the group of companies
that show positive earnings surprise.
The research result of the group of companies that show positive earnings surprise
proved that there is no difference in capital market reaction, which is proxied by CAR,
between income smoothing companies and non-income smoothing companies. The
208 I. Setiadi et al.

results of this study are consistent with several studies conducted by researchers before,
Subekti (2005) and Aisjah (2005), which states that there is no difference in capital
market reaction, which is proxied by CAR, between income smoothing companies and
non-income smoothing companies in a group of companies that show positive earnings
surprise. However the results proxied by the STV show that there is a difference in
the capital market reaction between income smoothing companies and non-income
smoothing companies in the group of companies that show positive earnings surprise.
Table 3 shows the independent samples test results in the group of companies that
show negative earnings surprise as follows. The F value of CAR on the Levene’s test is
0.447 with a significant value of 0.540, which is a significant value greater than 0.05.
The t value on the independent samples test is –0.540 and a significant value of 0.618
greater than 0.05, so it can be concluded that the market reaction, which is proxied
by CAR, does not differ significantly between income smoothing companies and
non-income smoothing companies in the negative earnings surprise group.

Table 3 The entire sample is companies that show negative earnings surprise

Independent samples test

Levene’s test for equality of variances t-test for equality of means
F Sig. T Sig. (2-tailed) Mean difference
CAR 0.447 0.540 –0.540 0.618 –0.00195
STV 2.709 0.175 1.971 0.120 0.00376
*, **, *** indicate significant at less than 10%, 5% and 1% level, respectively.
Where,
CAR: cumulative abnormal return of stock number-i in days-t which are calculated from
the beginning of the window period until the end of the window period, within five days
before and after earning anouncement.
STV: Stock trading volume mean.

The F value of STV on the Levene’s test is 2.709 with a significant value of 0.175,
because the significant value is greater than 0.05. The t value on independent samples test
is 1.971 with a significant value of 0.120, which is greater than 0.05, so it can be
concluded that the market reaction, proxied by the STV, does not differ significantly
between income smoothing companies and non-income smoothing companies in the
negative earnings surprise group.
The result shows that there is no difference in market reaction proxied with CAR,
so the results of this study are different from the study conducted by Assih and Gudono
(2000). Assih and Gudono’s (2000) study proved that there is a difference in the capital
market reaction to income smoothing companies and non-income smoothing companies
in the negative earnings surprise group. However, the results of this study are consistent
with some previous researchers, Subekti (2005), Aisjah (2005) and Juniar et al. (2007),
which states that there is no difference in market reaction, proxied by CAR, to income
smoothing companies and non-income smoothing companies in the negative earnings
surprise group.
 Market reaction on income 209

The test results with STV as a measure of market’s reaction showed significant
research results, which are consistent with research conducted by Subekti (2005) and
Juniar et al. (2007), which states there are different STV between income smoothing
companies and non-income smoothing companies in the negative earnings surprise
group.

5 Discussion

In the study of income smoothing, companies that belong to the group of income
smoothing companies will show a stable stream of income. This will cause the income
that will be announced relatively more predictable over the previous year’s income. In the
group of non-income smoothing companies, the income streams that have been published
show a high degree of variation; therefore, it is relatively difficult for an investor to
predict the income that will be announced only through the signal which is shown from
the information of previous period’s profit. If so, then the information that will be
announced by a company is crucial for investors and market participants (Agriyanto,
2006). Subekti (2005) stated that the Indonesian capital market has not responded in more
detail about a company’s income information according to efficient market theory.
Thus, it can be said that the efficiency level of capital markets in Indonesia is not
consistent yet.
This study provides split results. The researchers argue that there are other factors
that have a bigger effect for market reaction towards the income smoothing action.
This is consistent with Foster in Agriyanto (2006) stating that the other announcements
can affect stock prices, such as the announcement of forecasting from officials, the
announcement of dividend and the announcement that related to the government.
This study used secondary data from income statements of manufacturing companies
in Indonesia from 2009 to 2012. Indonesian economy during this period was affected
by the global economic crisis that may affect the condition of the capital markets in
Indonesia, which affects the stock price movement. So there is no difference in the
variability of return between income smoothing companies and non-income smoothing
companies, it is in accordance with research conducted by Nezky (2013) which states that
the global crisis is significantly affecting the capital market in Indonesia. Nezky (2013)
stated that Indonesia’s capital market is still strongly affected by foreign capital markets,
so if there is a shock on big foreign stock indices, it will easily cause panic among the
domestic investors. Therefore, the author argues that there is a relationship between
global financial crisis conditions on capital markets in Indonesia.
Market reaction which is proxied by volume is greater in non-income smoothing
companies than in income smoothing companies. This indicates that investors are more
interested in non-income smoothing companies than in income smoothing companies.
Indarti and Purba (2012) stated increase in the volume of trade is the increase in
trading activity of investors in the stock exchange, the greater the STV showed that
investor’s interest in a stock securities is greater and it is likely to result in rising prices or
returns of a stock. However, this study gives a different result that is a large STV has no
positive effect on the return as indicated by this research results, which show that market
reaction, proxied by CAR, is not significant. The researchers suspect that there is a
possibility of uneven distribution of information, causing that the market does not react to
the return. The uneven distribution of information causes that there are some market
210 I. Setiadi et al.

participants who receive information before the information is officially published, some
receive information too late and the rest do not even receive any information at all.
This study uses data from 2009 to 2012, to see market reaction in this period,
when the Indonesian economy was still affected by the global economic crisis, it will be
more accurate if the researchers proxied market reaction using STV than cummulative
abnormal return.

6 Conclusion, limitation and suggestion

6.1 Conclusion
On the basis of the analysis in the previous chapter, the researchers can draw conclusions
as follows:
• Market reaction on earnings announcement which is determined through
cummulative abnormal returns obtained a result that there is no difference of market
reaction on the group of income smoothing company and non-income smoothing
company. Thus, the proposed hypothesis is not proven. Market reaction on earnings
announcement which is determined through STV obtained a result that there is a
difference of market reaction on income smoothing and non-income smoothing
companies. Thus, the hypothesis proposed is proven.
• Market reaction on earnings announcement, which is determined through
cummulative abnormal return and STV on positive earning surprise group, obtained
a result that there is no difference of market reaction on group of companies that
show positive earning surprise. Thus, the proposed hypothesis is proven. Market
reaction on earnings announcement, which is determined through cummulative
abnormal return and STV on negative earning surprise group, obtained a result that
there is no difference of market reaction on group of companies that show negative
earning surprise. Thus, the proposed hypothesis is not proven.

6.2 Research limitations

This study still contains some weaknesses caused by the following limitations:
• the samples used are limited to manufacturing companies, especially basic industry
and chemicals sectors
• in classifying the income smoothing and non-income smoothing companies, this
study only uses Eckel index
• the calculation of unexpected earnings in this study only uses earnings
approximation model of zero growth model
• the researchers ignore the impact of earnings announcements that contain good news
and bad news that may affect market reaction.
 Market reaction on income 211

6.3 Recommendation
In connection with these limitations, then the recommendations for future research are as
follows:
• use a larger sample of not only manufacturing companies in basic industry and
chemicals, but also other sectors with the aim of comparable magnitude to the
reaction between the various sectors of the market
• use another model to calculate unexpected earnings as market expectation models,
because this research is linking profit expectations with stock prices
• consider the impact of earnings announcements that contains good news and bad
news in seeing market reaction.

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Website
http://www.idx.co.id/