An-Najah National University Faculty of Graduate Studies THE IMPACT OF INCOME SMOOTHING AND EARNINGS QUALITY ON THE VALUATION OF COMPANIES: A CASE OF PALESTINIAN COMPANIES By Fatheyeh Hakam Najar Supervisor Dr. Ra’fat Jallad This Thesis is Submitted in Partial Fulfillment of the Requirements for the Degree of Master of Finance, in the Faculty of Graduate Studies, An-Najah National University, Nablus, Palestine. 2022 ii THE IMPACT OF INCOME SMOOTHING AND EARNINGS QUALITY ON THE VALUATION OF COMPANIES: A CASE OF PALESTINIAN COMPANIES By Fatheyeh Hakam Najar iii Dedication علَّمتنا ما إال لنا علم ال اللهم األمين، الوعد الصادق محمد سيدنا على والسالم والصالة العالمين، رب هللا الحمد .علما وزِدنا علَّمتنا، بما وانْفعنا ينفعنا، ما علِّمنا اللهم الحكيم، العليم أنت إنَّك ، الدنيا ضافت حين حلمي يحضن ان اماله واتسعت ، األمل نحو بي عبرت التي النور بؤرة الى تخرجي أهدي أجل من نعيش ان معنى وعلمني طريقي، في النور معاني ليغرس الدرب في وسار أجلي من الصعاب فروض شهادة حامال ليراني شوقا عيناه وحنت قلبة تفطر ولطالما ، اجسادنا أرواحنا فارقت لو حتى أحياء لنظل العلم الحبيب أبي. يديك بين اليوم ألقدمها أينأت قد هي وها الماجستير فتبقى ، قلبي في االمل وتغزل الحب تمتهن التي الى ، ذاتها مكنون عن معبرة لتخرج الكلمات تتسابق من الى .الحبيبة أمي. دربي عنوان دعواتها كانت طالما مشرقة، روحي التعليمية الكوادر كافة والى العزيزة جامعتي الى الدراسة في زمالئي الى واخوتي جميعا عائلتي الى واإلباء العزة جنين أحببت التي وأهلها مدينتي الى الكريم لوجهه يجعله وأن به ينفع أن وجل عز المولى سائالً الدراسية سنواتي ثمرة أقدم iv Acknowledgment I would like to thank my supervisors Dr. Ra’fat Jallad for his valuable advice and suggestions, and for allocating sufficient time to discuss questions and write this research. v Declaration I, the undersigned, declare that I submitted the thesis entitled: THE IMPACT OF INCOME SMOOTHING AND EARNINGS QUALITY ON THE VALUATION OF COMPANIES: A CASE OF PALESTINIAN COMPANIES I declare that the work provided in this thesis, unless otherwise referenced, is the researcher’s own work, and has not been submitted elsewhere for any other degree or qualification. vi Table of Contents Dedication .................................................................................................................................... iii Acknowledgment ......................................................................................................................... iv Declaration .................................................................................................................................... v Table of Contents ......................................................................................................................... vi List of Tables ............................................................................................................................... ix List of Figures ............................................................................................................................... x List of Appendices ....................................................................................................................... xi Abstract ....................................................................................................................................... xii Chapter One: Introduction ........................................................................................................ 1 1.1 Introduction ............................................................................................................................. 1 1.2 Research Problem ................................................................................................................... 3 1.3 Research Questions ................................................................................................................. 3 1.4 Research Objectives ................................................................................................................ 4 1.5 Research Significance ............................................................................................................. 4 Chapter Tow: Literature Review .............................................................................................. 6 2.1 Theoretical Framework ........................................................................................................... 6 2.1.1 Earnings Management .......................................................................................................... 6 2.1.2 Signaling of Earnings Management Theory......................................................................... 8 2.1.3 Agency Theory ..................................................................................................................... 9 2.1.4 Income Smoothing ............................................................................................................. 10 2.1.5 Earnings Quality ................................................................................................................ 12 2.1.6 Factors Affecting Earnings Quality ................................................................................... 14 2.1.7 Importance of Earnings Quality ......................................................................................... 15 2.1.8 Earnings Quality and Income Smoothing .......................................................................... 15 2.1.9 Business Valuation ............................................................................................................. 15 2.1.10 Relationship between Earnings Quality and Value of the Company ............................... 17 2.1.11 Efficient Market Theory ................................................................................................... 18 vii 2.1.12 Relationship between Income Smoothing and Value of the Company ............................ 20 2.2 Previous Research ................................................................................................................. 21 2.2.1 Income Smoothing Improve Firm Value ........................................................................... 21 2.2.2 Income Smoothing Diminish Firm Value .......................................................................... 23 2.2.3 Earnings Quality Improve Firm Value ............................................................................... 24 2.2.4 Earnings Quality Diminish Firm Value ............................................................................. 25 2.2.5 The Association between Earnings Quality and Income Smoothing on Firm Value ......... 25 2.3 Conceptual Model ................................................................................................................. 25 2.4 Hypothesis Development ...................................................................................................... 26 Chapter Three: Methodology................................................................................................... 27 3.1 Population and Sample .......................................................................................................... 27 3.2. Data Collection .................................................................................................................... 27 3.3 Econometric Model ............................................................................................................... 27 3.4 Variables of the study ........................................................................................................... 28 3.4.1 Dependent Variables .......................................................................................................... 28 3.4.2 Independent Variables ........................................................................................................ 29 3.4.3 Control Variables ............................................................................................................... 32 Chapter Four: Analysis and Results ....................................................................................... 35 4.1 Introduction ........................................................................................................................... 35 4.2 Descriptive analysis .............................................................................................................. 35 4.3 Correlation Matrix ................................................................................................................. 37 4.4 Models Estimation ................................................................................................................ 38 4.4.1 First Model (TQ) ................................................................................................................ 38 4.4.2 Second MODEL (ROE) ..................................................................................................... 40 4.5 Diagnostic Test ..................................................................................................................... 41 4.5.1 Variance Inflation Factor (VIF) ......................................................................................... 41 4.5.2 Heteroscedasticity Test ...................................................................................................... 42 4.5.2.2 Model 2: ROE Ratio ....................................................................................................... 42 viii 4.5.3 Autocorrelation Test........................................................................................................... 43 Chapter Five: Conclusion and Recommendation .................................................................. 44 5.1 Introduction ........................................................................................................................... 44 5.2 Results ................................................................................................................................... 44 5.2.1 Earnings Quality on the Value of Company ...................................................................... 44 5.2.2 Income Smoothing on the Value of Company ................................................................... 45 5.2.3. Control Variables on the Value Company ........................................................................ 46 5.3 Conclusion ............................................................................................................................ 47 5.4 Recommendations ................................................................................................................. 48 5.5 Limitations ............................................................................................................................ 48 List of Abbreviations .................................................................................................................. 49 References .................................................................................................................................. 50 Appendices ................................................................................................................................. 62 ب ........................................................................................................................................... ا>;:89 ix List of Tables Table (1) Market Capitalization ( as of December 2019) Across Sectors ........................ 27 Table (2) The Descriptive Statistics ....................................................................................... 37 Table (3) The correlations Matrix .......................................................................................... 38 Table (4) TQ - FGLS ............................................................................................................... 39 Table (5) ROE- FGLS .............................................................................................................. 41 Table (6) Variance Inflation Factor (VIF) ............................................................................. 42 Table (7) TQ- White's test ....................................................................................................... 42 Table (8) ROE- White's test .................................................................................................... 43 x List of Figures Figure (1) Conceptual Model .................................................................................................. 26 xi List of Appendices Appendix (A) Sample of companies across 3sector in Palestine exchange ..................... 62 Appendix (B) Previous Studies .............................................................................................. 64 Appendix (C) Variables and Measurements ......................................................................... 70 Appendix (D) Serial Correlation Test: TQ ratio .................................................................. 72 Appernidx (E) Serial Correlation Test: ROE ratio ............................................................... 73 Appendix (F) POLS -Tobins Q .............................................................................................. 74 Appendix (G) Fixed Effects Model -TQ ............................................................................... 75 Appendix (H) Random Effects Model -TQ .......................................................................... 76 Appendix (I) Hausman (1978) Specification Test ............................................................... 77 Appendix (J) Robust Fixed Effects Model ........................................................................... 78 Appendix (K) Nested Regression ........................................................................................... 79 Appendix (L) POLS - ROE ..................................................................................................... 80 Appendix (M) Fixed Effects Model -ROE............................................................................ 81 Appendix (N) Random Effects Model -ROE ....................................................................... 82 Appendix (O) Hausman (1978) specification test ................................................................ 83 Appendix (P) Robust Fixed Effects Model ........................................................................... 84 xii THE IMPACT OF INCOME SMOOTHING AND EARNINGS QUALITY ON THE VALUATION OF COMPANIES: A CASE OF PALESTINIAN COMPANIES By Fatheyeh Hakam Najar Supervisor Dr. Ra’fat Jallad Abstract This thesis investigates the effect of income smoothing and earnings quality on the valuation of companies listed in the Palestine Exchange market using annual data covering the period between Jan 2010 to Dec 2019. Income smoothing is qualified as reducing the fluctuations in the reported income within the accounting standards and is detected by the model of Eckel (1981). Managers have several motivates to smooth their reported incomes, for example, to optimize their bonus rewards. Panel analysis was used in this thesis. To achieve the objectives of this research, the researcher employed FGSL. The results indicate that earnings quality as measured by timeliness is significantly negatively influencing TQ and ROE. However, earnings quality as measured by accruals is significantly positively influencing ROE. Income smoothing has been significantly positive with ROE. Future studies on income smoothing and earnings quality may consider the financial sectors in the Palestine Exchange(PEX). Apply another method in measuring the variables of the study. Key Words: Income Smoothing, Earnings Management, Persistence, Earnings Quality, Eckel Model , Palestine. 1 Chapter One Introduction 1.1 Introduction Financial markets play a crucial role in the business development process because published information representing the state of the market and the assets traded attract investors and accumulated savings and directs them to suitable investments to provide investors with the best available investment options, especially in an efficient market (Fama, 2004). Investors usually care about two things: the size of the profits, the higher is the better, and their sustainability. Therefore, the company’s management seeks to make its profits sustainable, if the profits for this year are unusually high, it tries to smooth them for the need of future periods (Bao & Bao, 2004). However, administrators and economic units use accounting tools to improve their competitiveness in the market although this change is not real, whether for profitability or the financial situation, they exploit the gap in accounting methods and take the advantage of accounting alternatives in evaluation and disclosure to prepare financial statements. Companies usually resort to smooth its earnings for several reasons, including: avoiding losses and affect the quality of accounting information or reduce the deviation in income to keep the profit rate within certain limits or affect the tax rate due on them, and the most important goal is to gain the confidence of shareholders and bondholders (Al-Taie et al., 2017). Earnings management is characterized by the concept of flexibilitym, it uses the flexibility provided by accounting standards to manipulate its earnings .This situation results in the management of the company not reporting the actual profits that occurred in a particular period. Since critics say that shareholders and other outside parties are misled by management about the company's actual financial condition, this manipulative aspect of the use of earnings management creates a questionable view of whether earnings management is morally justified (Skinner & Soltes 2011). Earnings quality is an important factor in determining a business's financial health, but creditors, investors, and other financial statement users are not aware of it. The ability of reported income to reflect the company's actual income is referred to as earnings quality. Companies that manipulate their profits are considered companies with low 2 profit quality, as high quality companies adhere to generally accepted accounting principles standards and are reliable and sustainable. Earnings quality also refers to the persistence, stability, and consistency of reported earnings (Bellovwy & Don, 2005). Earning management is one of the factors that influence earnings quality. One of the earning management methods that have a direct impact on earnings quality is income smoothing (Sri KUSTONO et al., 2021). Income smoothing is a well-documented phenomenon. although it has been revealed to varying degrees in different measurements, the technique or approach evaluation used to identify the income smoothing companies has been a popular focus of discussion in previous income smoothing investigations (Mohamad,2001). Eckel in (1981) separates income smoothing as a natural smoothing and income smoothing that is intended smoothing. This thesis is an extension of the prior literature focusing on income smoothing and earnings quality, especially in emerging economies. However, it enriches the literature by applying to companies listed on the Palestine Stock Exchange (services, industry, and investment sectors) where there is a difference in the environment that contribute to the lack of literature on this topic. Investors' use of the company's financial statements depends on the management's behavior in preparing the financial statements and the way the company's performance is presented. It means that the administration has the freedom to choose the accounting methods in disclosing its financial statements to influence revenues and income to achieve profit stability and to motivate investors to invest in their company (Beneish, 2001). So, how does the smoothing and quality of earnings affect the valuation of companies listed on the Palestine Exchange? This thesis attempts to answer this question by investigating the effect of income smoothing and earnings quality on the valuation of companies listed on the Palestine Exchange. This thesis aims to fill the existing gap in the relationship between earnings quality and the value of the company. This thesis is unique and different by applying for the first time to the non-financial sectors of the Palestine Exchange (PEX). This thesis is to examine whether the valuation of listed firms in the Palestine Stock Exchange is influenced by income smoothing practices and their quality of earnings. 3 1.2 Research Problem The objective of preparing financial reports is to provide information about the firm's performance that contributes to making economic decisions for stakeholders such as suppliers, investors, creditors, and managers (Nyaruwata,2018). The quality of profits must be studied in terms of the interests of shareholders, and this issue raises the consideration of income smoothing and management of the quality of profits, and whether this position of managers serves the interests of investors. Additionally, how does this earnings management affect the company's valuation? It is believed that the more sustainable the profits the higher the quality. One of the most determinants of investing in the financial markets in developing countries is the quality of financial reports, which consider a constraint for global investment funds to invest in Palestine. Because of its importance in representing a real expression of the company's earnings and thus the ability to predict the company's future performance. In Palestine, there is a scarcity of studies on the effect of income smoothing and earnings quality on corporate performance. This thesis attempts to fill this gap and determine whether the company's valuation can be affected by income smoothing and earnings quality. 1.3 Research Questions This thesis aims to answer the following two main questions: Q1. What is the impact of earnings quality on the valuation of firms listed in Palestine Exchange (PEX)? This question is decomposed in a number of sub questions as follows: Q1.1. What is the effect of accruals quality on the valuation of firms listed in Palestine Exchange (PEX)? Q1.2. What is the effect of timeliness of earnings on the valuation of firms listed in Palestine Exchange (PEX)? Q1.3. What is the effect of persistence of earnings on the valuation of firms listed in Palestine Exchange (PEX)? 4 Q2. What is the impact of income smoothing on the valuation of firms listed in Palestine Exchange (PEX)? 1.4 Research Objectives This thesis aims at identifying the phenomenon of income smoothing degree and earnings quality of companies listed on the Palestine Exchange (PEX) from 2010 to 2019 and offering distinct contributions to the existing literature in terms of income smoothing throughout several aspects. First, this thesis aims to fill the scarcity of studies on the effect of income smoothing and earnings quality on the valuation of companies by applying the first empirical study to companies listed on the Palestine Exchange (PEX). Second, this thesis aims to reveal the potential relationship between income smoothing and earnings quality and its impact on the valuation of firms listed on the Palestine Exchange (PEX). 1.5 Research Significance This research is unique and different from other studies for the following reasons. First: The Environment There is a difference in the environment, whether legally or financially, as this research was applied to the companies listed on the Palestine Stock Exchange for the first time (services, industry, and investment). Second: Investment Increase shareholder confidence in the stock market by clarifying standards of quality and accuracy, saving efforts, cost, and timeliness of financial statements. Third: Regulators It will be beneficial for decision-makers, regulators, and authorities such as the Palestinian Capital Market Authority (PCMA) to maintain the integrity of the financial reporting system and legislative laws related to the financial aspects that attract foreign investment such as compliance with international accounting standards and electronic disclosure of investment-related sectors to maintain the quality of profits . 5 This thesis is organized as follows. In the next chapter, discussing the literature review including the concepts and relationships between variables of research, the third chapter shows the research methodology and the method of measuring variables, the fourth chapter includes statistical tests to examine the relationship between the variables, and the final chapter discusses the results and recommendations of the research. 6 Chapter Tow Literature Review 2.1 Theoretical Framework 2.1.1 Earnings Management Earnings management occurs when management uses its reporting judgment to deceive some stakeholders about the company’s performance or to impact results that rely on reported accounting information (Zarowin, 2002). There are variety of ways to management the earnings. Income smoothing is one of the most important tools that aims to reduce fluctuation over the time (Eckel ,1981). Although most researchers tend to show the negative side of earnings management, some have taken the opposite position and describe them as legally and acceptable measures, which, when used, for example, within the income smoothing method, aim to achieve an element of the relative stability of earnings that makes them predictable. Ronen and Yasser (2008) take a middle ground between the two previous viewpoints, believing that the impact of earnings management can be beneficial if viewed as offering stakeholders and owners and with an indication of the firm's long-term performance, even if it is hidden short- term performance. The process of earnings management practice aims at mislead the stakeholders about the economic performance of a company, make financial reports more informative to the users by choosing between different accounting alternatives and using personal estimates, concealing poor financial performance, postponing the current unexpected profits to future years, and enhancing the performance of the enterprise for the period The current rate by increasing the established positive profit number (Ronen & Sadan,1975). It is necessary to discuss aspects of the earnings management modeled by Beidleman (1973). A. Beneficial This indicates that the information in the financial statement is more transparent. Where the company's management takes the advantage of the flexibility of accounting methods to affect financial reports. When the firm's profits increase unusually in the current year, 7 the company transfers part of it and postpones for the need of the next period. This makes the company's profits more sustainable, which makes the investor more confident in the company's performance because the information risk is reduced. B. Pernicious Financial reports do not truly represent the company's performance, management is misleading stakeholders by using unethical methods and influencing its decisions. It may contribute to minimizing firm value. For example, a company decides to buy a car for $200,000 and asks the company to take it over next year. Next year, management cancels the purchase. In this case, the company benefits by recording it as a cost in the year of purchase and reducing the profits for that period by $200,000. Tools of Earnings Management Management employs a variety of strategies and instruments to manage its earnings, these methods are as follows. A. Change of Accounting Methods and Policies It is a change of financial information calculation to present its financial statement, where the company selects among the permitted accounting methods, this tool is considered the most common, it usually choose what is commensurate with its goals, which will achieve the target level of profits as it affects the timing and values of revenues and expenses that are recognized during the accounting period, and consequently on the earnings of that period, for example, a change from FIFO to LIFO or FIFO to weighted average method (Ronen & Sadan,1975) B. Change of Accounting Estimation Change in actual financial information such as provisions and reserved to achieve temporary or current benefits, for example, changing the depreciable life of a material asset. These changes play on the time factor, and their effects are reflected on the timing of recording and monitoring the impact in the financial statements, as well as a revenue burden. The objective of the provision form is to allocate unrecognized risks (Kieso et al., 2019). 8 C. Change in Items Classification It influences the income reported and decrease unanticipated deviation from unusual item regular transactions of the business. For example, the company purchased equipment with a value of $1,000,000. It has two options to record this process. The first one record it as an expense in the income statement, thus reducing the profits for that year by $1,000,000, or record it as an asset that is depreciated over 5 years, so the share of that year is $200,000, and this increases the profits of that period by $800,000 (Fudenberg & Tirole, 1995). D. Timing of Sales Investments Controlling the individual operations ; especially the investment and their timing in a way that serves to show the numbers in a way that benefits the administration. Its clear example is maintaining an investment portfolio with profitable and losing items, on- demand, as the company sells part of its successful investment in case it needs to increase revenues, and gets rid of the losing investment at the moment it needs to reduce revenues, even though the company does not work primarily in the field of investments (Godwin, 1977). E. Income Smoothing Tools used by management to shift a portion of the profit earned in a high-volatility year to a low-volatility year to minimize variations in the periodic profit amount (Eckel, 1981). After understanding the terms of earnings management, the scenario in which earnings management is likely to occur will be studied. The signaling earnings management theory, agency theory, and efficient market theory all assist in explaining the use of earnings management. 2.1.2 Signaling of Earnings Management Theory The signaling theory of management states how managers can send signals to investors indirectly that show the company's future ability to rely on this information about future cash flows, it can provide information that indicates signals of success or failure in firm operations. Depending on the content of the management information, this signal might have positive or negative implications (Huang, 2013). 9 According to proponents of the signaling theory, managers management the earnings to transmit inside information about a company's future performance therefore, it acts as a signaling mechanism. Managers may have the ability to influence stock prices, through earnings management. Earnings management can serve as a signal mechanism for management to disclose inside information about the company to investors (Sun & Rath, 2008). Moreover, managers would prefer to present a smoother profits stream to signal the consistency of the company's underlying profits process. As a result, creditors reduce their assessment of the likelihood of the company's insolvency, increasing the firm's worth. When manager fails to satisfy investors' expectations is viewed as an indication of underlying problems in the business, which the company would be heavily punished (Trueman & Titman, 1988). Hejazi et al., (2011) discovered that managers are ready to sacrifice long-term value to fulfill earnings expectations. 2.1.3 Agency Theory The agency theory is reorganized as a result of the separation of ownership and management in public businesses, in which the managers act as the agents and the stakeholders are the principals. This agency relationship is defined as a contract in which the principals employ the agent to execute service on their behalf, which includes delegating certain decision-making authority to the agent. This theory assumed the existence of efficient markets and contracts. Furthermore, managers only care about their interests and so do not always behave in the best interests of the principals. Contracts will prohibit managers from preferring their interests over the interests of stakeholders (Yueng,2009). Jensen and Meckling (1976) recognized agency problems such as moral hazards: shirking problems and adverse selection. Adverse selection is adopting accounting decisions that maximized reported revenue in order to receive a greater bonus. The shirking problem arose from the principal capacity to directly observe the manager's work, and the principal can only judge a manager's performance based on the result presented through the annual report (Zhai and Wang, 2016). Vasiljević (2009) asserted that agency theory proposes strategies for lowering agency costs, which can take the shape of incentive programs for managers and the installation of control measures (e.g., management control system). Compensation and benefits programs are regarded as critical in reducing the conflict of interest between owners and shareholders . 10 Panda and Leepsa (2017) argued that strict accounting principles restrict the manager's ability to act in an opportunistic manner that does not serve the interests of the company's owners or investors, so the greater the flexibility in accounting methods, the greater the manager's ability to use his discretion and engage in earnings management activities and manipulate the reported accounting information. 2.1.4 Income Smoothing Income smoothing defined as the set of tools to reduce the fluctuations in the earnings is considered normal for the company under the principles of accounting and management (Beidleman, 1973). Smoothing refers to profit adjustments that occur over two or more consecutive periods, and identifying them requires data analysis for at least three periods; while a two-year comparison may show that the second period's profit increased or decreased, it is insufficient for identifying a behavior pattern in any one company (Copeland, 1968). 2.1.4.1 Motives of Income Smoothing There are many motives behind income smoothing, according to the context of most of the previous studies, which were divided into the following groups: A. Motives Related to Contracts • Management reward contracts: Although management's official mission is to maximize shareholders' wealth, it may have personal motives that differ from those related to achieving the basic objective of the company that drives it to make decisions and actions that affect it. In the event that the actual earnings are above the limit, the management’s motive is to reduce the current period's earnings to guarantee the continuity of the reward over the next period. However, if the actual earnings are less than the minimum limit, the motive of management is to increase the earnings of the current period at the expense of subsequent periods to ensure obtaining rewards in the current period (Hejazi et al.,2011). • Debts Covenants: Contracts between lenders and the company under which covenants are placed on management actions to reduce the agency problem between the shareholder and debtholder. Breach of covenants set into the agreements is one of the main motives for the exercise of income smoothing 11 through choosing accounting methods and policies that increase the benefit of shareholders without prejudice to the terms of debt contracts (Saringat et al.,2013). • Work contracts: management try to reduce any proposed increases in wages. Most companies conclude contracts with workers based on a fixed wage and a reward determined based on a percentage of the earnings. Therefore, any sharp increase in the declared earnings would motivate the workers to demand raise in their salaries. Management tries to adopt income smoothing practices, to show the stability of earnings to prevent any labor claims (Saringat et al.,2013). B. Motives Related to Financial Markets Companies aim to send positive signals to the market about their current performance by disclosing positive financial reports that boost their market prices. Therefore, companies smooth their income to reflect positive prospects about their future profitability and would influence analysts' and investors' estimates of the riskiness of future cash flow (Emad et al.,2020). 2.1.4.2. Empirical Methods of Income Smoothing Copeland (1968) states that there are several methods have been used to empirically measure the practices used by management to smooth their income. These methods include: interviewing, questioners, and observation. However, he indicates that the application of the above methods is difficult. He mentions a second procedure that based on contacting third parties, such as CPAs, who are familiar with the procedure used by management. In addition, a third approach proposed by him that is based on the financial statements and reports. 2.1.4.3. Classification of Income Smoothing Two main classifications of income smoothing have been cited by (Bao & Bao,2004), (Akbari etal.,2018), (Susanto& Pradipta,2019), and (Abogun etal.,2021) A. Natural smoothing It is smooth that results from the natural process of generating profits in the company without having any unnatural influence on it, for example, electricity companies (Hejazi et al., 2011). 12 B. Intended smoothing This type also named management smoothing can be broken into artificial and real: Artificial: manipulations by management to smooth the income to affect cash flow indirectly but shift the cost and/or income from one period to the next. Management can time actual transactions so that their effect on reported profit is controllable. This reflects the represented in the management’s manipulation in the timing of income recognition by exploiting the flexibility available in the generally accepted accounting principles (Al Baaj et al.,2018). Real: It results from real business exchanges and operational decisions that require certain expenses to produce certain profits, and are implemented by management to reduce the volatility of cash flows (Etemadi & Sepasi,2008). 2.1.5 Earnings Quality Higher quality earnings more faithfully represent the character of the firm’s fundamental earnings process relevant to a specific decision. Because the relevant features of the firm's fundamental earnings process differ across decisions and decision- makers, our definition implies that the concept earnings quality is meaningless without specifying the decision context (Dechow etal., 2010). Accounting researchers continue to use the descriptor quality to refer to earnings' decision-usefulness in equity market valuation. Nonetheless, the term has been applied to other contexts, most likely as a result of our conversational understanding of quality as an indication of superiority or excellence. This progression of a term like earnings quality to its current state of ambiguity is not unusual (Bellovwy& Don, 2005). The concept of earnings quality varies according to users' perspective of financial statements and their goals. From the perspective of accounting standards setters and auditors company quality of earnings can be achieved when they closely stick to generally accepted accounting principles (Dechow&Schrand, 2004). 13 From the perspective of creditors, the quality of earnings is related to converting them into cash flows that are sufficient to cover the firm's obligations towards them (Bellovwy& Don, 2005). From the analyses’ perspective, it has been defined as the ability of earnings to describe the operating performance of the company, where the information is accurate, arrives on time, can persist itself into the next period, and is free from earnings management practices (Bao & Bao,2004). We found that there are different views of researchers about the characteristics that must be available in quality of earnings. According to previous studies, it was shown that the most consistent earnings quality characteristics is derived from the following: 2.1.5.1 Timeliness Measure the ability of earnings to calculate changes in economic value by integrating all information in the market on time from a variety of sources( up to the second data) (Dichev etal .,2012). Ensuring the timelines of processing requires the ability to collect, transfer, process, and present the stream data in real time, can be measured as the time between when information is expected and when its available for use . Information that is not timely can lead to people making the wrong decision (Ball&Shivakumar,2005). 2.1.5.2 Persistence It is define as the ability of current earnings to predict the future earnings , where the value of each share of the company's shares does not depend entirely on the company's current earnings. However, it depends on this company's expected profitability and reliability based on these profits (Francis et al. 2008). 2.1.5.3 Accruals Dichev & Dechow (2002) developed the first model for measuring the quality of earnings using the quality of accruals non-cash expenses and revenues recorded in the financial period regardless the time of exchange or receipt. The accrual estimation process is the core of financial reporting, the basic logic is that accruals will be converted into cash flows. Since it must be made within generally accepted accounting 14 principles (GAAP), and specialists are consulted for estimates, the correct estimation of accruals will help increase investor confidence in your financial statements, where accruals are highly associated with future earnings performance (Hejazi et al.,2011), Since accruals are based on certain estimates, incorrect estimates of expenses and revenues reduce the benefit accrued from the accrual process (Lyimo,2014). 2.1.6 Factors Affecting Earnings Quality Previous literature examine the factors affecting the quality of earnings that would increase or decrease the quality of earnings according to their direction and degree of impact. The main 6 factors are as follows: A. The Quality of Accounting Standards: the strictness and stress on companies to use standards will reduce the exploitation of gaps in the accounting principles, which increases the earnings quality (Ewert & Wagenhofer, 2013). B. Differences in Accounting Standard: there is a difference between local and international standards in preparing financial reports to represent an important factor in influencing the quality of earnings because the companies that follow international accounting, especially the International Financial Reporting Standards (IFRS), raises the level of the quality of earnings (Barth etal., 2008). C. Shareholder Composition: The quality of earnings increases in companies with a higher percentage of members independent board of directors because earnings management practices are lower in companies with a higher percentage of independent members of the board of directors, which enhances the quality of earnings (Alves, 2014). D. Shareholder Control: in certain socialist nations, the state controls a percentage of a company's shares to decrease the percentage of shareholder ownership less than 50% and affects the quality of earnings in these firms (Ramadan, 2015). E. The Effect of Board of Directors Members on the Quality of Earnings: the more members of board of directors, the more manipulation of the financial statements, which reduces the quality of earnings (Ramadan, 2015). 15 F. The Impact of the Audit Committee on the Quality of Earnings: the more meetings of the audit committee, the higher the quality earnings, and this means that forming an audit committee and increasing its members would improve the quality of earnings (Lin,2006). 2.1.7 Importance of Earnings Quality The importance of earnings quality increased in the 1990s when the US Securities and Exchange Commission discovered the manipulation by managers and auditors. These committees accused managers of focusing on managing opportunistic earnings to meet the expectations of the capital market. Managers had several motives, including increasing interest in evaluating companies through their performance in the financial market, increasing the company's value in the market, job security for managers in addition to their compensation, and showing the company's earnings more than reality, it gives a good picture of company’s performance (Bellovwy& Don,2005). 2.1.8 Earnings Quality and Income Smoothing Earnings management can enhance the quality of earnings, improving the quality of earnings can make information about income for the current period more valuable in forecasting future earnings; one earnings management measure that may have an effect on the persistence of earnings is income smoothing (Sri KUSTONO et al.,2021). Income smoothing enhance earnings information content if managers employ their judgment to express their evaluation of future earnings, whereas income smoothing allows users of financial statements to anticipate future earnings based on current earnings information (Susanto&Pradipta,2019). The impact of income smoothing on earnings persistence is explained by the fact that income smoothing decreases earnings volatility between periods. Income smoothing can make a profit, whereas past earnings are more useful by communicating future earnings (Ariamand&Ebrahimi,2020). 2.1.9 Business Valuation The method of estimating the economic value, establishing the company's current value using objective criteria, and evaluating all business areas is known as company valuation. A company valuation may include examining the company's management, financial structure, and expected earnings in the future (Gordon,1962). 16 There are various methods and tools for measuring and evaluating business value. The market price is one of the most important elements that reflect the company's potential to generate cash flow and the most important methods measure the performance as well as the risk associated with achieving the predicted cash flow because it considers the long-term interests of shareholders in a company (Susanto& Pradipta,2019). Profitability and growth determine the firm's value. The value of the company is influenced by financial strategy and its product market. The financial market strategy is implemented by dividend policies and financing, whereas the product market strategy is implemented through the firm's competitive strategy, operational policies, and investment decisions. As a going concern, there are three main valuation approaches: 2.1.9.1 Income Approach A business valuation expert resorts to this approach when it is difficult to obtain reliable data from the market; the income approach evaluates a business by converting the expected economic benefits into a single current amount. This method is powerful and effective because it does not depend on any previous similar transactions in the market. However, since the value used is very sensitive to estimates of growth rate and required rate of return, these inputs must be valid. The methods vary in income approach but usually fall into one of two categories: A. Capitalization of Earnings or Free Cash Flow By calculating the net present value (NPV) of expected future earnings or cash flows. This estimate is determined by taking the entity's future earnings and dividing them by the capitalization rate. B. Discounted Cash Flow (DCF) The total value of a business is the present value of its expected future earnings plus the present value of its terminal value. In this process, the expected cash flow of the business over some time in the future is first projected. Then, each separate cash flow is discounted to its present value at a rate that reflects the risk of receiving that amount at the time expected in the projection. Such forecasts are best represented by capital expenditures, operating costs, revenue, and working capital (Pastor et al., 2007). 17 2.1.9.2 Market Approach The market method is focused on the principle of comparing the business sales of the company with a similar company in the same business, this might result in a company being undervalued or overpriced. It is useful when evaluating public companies because their data is easily available. This approach includes many methods, including the indicative method of the public company, this method takes into account the market value of the stocks of the public company Comparable or the so-called guideline by calculating the pricing multiplier by dividing the price of a similar share by an economic variable and the second method is the Merger and Acquisition (M&A) method. The expert in this case establishes pricing multiples based on real-world transactions involving comparable full firms or operating units sold. These price multiples are then applied to the subject company's economic factors, such as net income (Miciuła et al., 2020). 2.1.9.3 Asset Approach This method depend on the total fair market value of the company's assets (FMV). The value generated by this approach is called the "level of control", which expresses the value of the owner who has the power to sell or liquidate the company's assets. If this approach is used to value minority interests, it is appropriate to obtain a discount due to lack of control (DLOC), which is widely used for holding companies and asset- intensive and troubled companies. This approach also incorporates the book value and adjusted net asset methods. The disadvantage is the failure to account for unrecorded intangible assets and the reliance on historical costs rather than the current fair market value. The adjusted net asset method converts the book values to fair market value and accounts for all intangible assets and liabilities (Moody & Walsh, 1999). 2.1.10 Relationship between Earnings Quality and Value of the Company Earnings are the focus of attention for stakeholders in the financial markets, especially investors and analysts. Ball & Brown (1968) discovered an important relationship between profits and returns; it became difficult to ignore the importance of profit quality in trading. Francis et al. (2008) explain that earnings are the main source of information due to indicating future cash flows. Therefore, it is necessary to identify the main features of 18 the quality of earnings because stakeholders will judge the company's performance on its basis. A measure of earnings quality is based on three earnings attributes (persistence, timing, and accrual quality). The purpose of the presentation of financial statements should provide useful signals to users in making their decisions, which are related to sustainability and timeliness, which means more permanent and transitional earnings so that users of financial statements can view them as high-quality earnings as well as accrual quality which is a good proxy for earnings quality. Financial reporting is strictly defined as "To be reliable, information must faithfully represent the transactions and operational performance of the company on time (Lyimo, 2014). 2.1.11 Efficient Market Theory The Efficient Market is a hypothesis in financial-economic states that the asset prices reflect all available information. Economic researcher Eugene Fama developed an efficient market in 1970 (Timmermann & Granger, 2004). The efficient market hypothesis (EMH) states that "capital markets respond to publicly available information efficiently and fairly." Because the stock market is so competitive, it is expected that new public information will be reflected in share prices immediately. To support this argument, assumptions about the present value of future cash flows involving that share determine the share price. When these beliefs change (due to the disclosure of public information), the expectation is that share prices will also change (Malkiel, 1989). According to Fama (1970), the efficient market hypothesis states that the stock price represents all available information, and investors will not be able to outperform the market. (Fama,1970). The EMH assumes that EM enhances decision-making and internal control, such as lowering taxes, monitoring managers, decreasing opportunism, and lowering contracting costs. Investors are rational, and they can lend and borrow simultaneously; information must be quickly and free to flow. Market anomalies should not exist since they will be arbitraged instantly. The EMH has three forms: First, there is a weak form in which current stock prices fully reflect all previous information, implying that past data cannot be utilized to forecast future prices. Second, semi-strong in which the current price quickly reflects all publicly available information (historical and current). Third, in this form, the price completely represents all accessible information, whether publicly available or not (Malkiel, 1989). 19 Financial markets are an important body in any economic sector around the world, which requires the need for scientific methods to evaluate investments, reduce uncertainty, and encourage investors to make an investment decision because investing in stocks is not easy due to the difficulty of estimating the return (Bartholdy, 2005). When making investment evaluations and decisions, it is critical to estimate the expected return and stock price. Investors and financial managers want to reduce their risk when investing in a stock. These problems have recently been solved by using financial tools to determine the future orientation of an investment. Modern finance theory has offered several insights into how stock prices are established, as has a quantitative description of the risk structure of equilibrium expected returns (Merton, 1980). Fundamental analysis has been the primary instrument used by financial market operators in evaluating the value of listed companies. It is well known that the goal of fundamental analysis is to define ideal portfolio strategies through macroeconomic and microeconomic indicators. Fundamental analysis evaluates the value of securities using publicly available data (such as bonds and stocks); an investor can use fundamental analysis on a bond's value by looking at an interest rate. For the stocks, investors can use earnings, future growth, and return on equity to determine a company's value and potential for future growth (Campanella et al., 2016). 20 2.1.12 Relationship between Income Smoothing and Value of the Company There is no clear correlation between income smoothing behavior and its effect on company value in many cases. Over time, the strategies used in profitability, contracts, management style, financing, and lending options vary, which changes this effect from positive to negative. However, GAAP gives management flexibility when reporting information and choosing an accounting method to use within legal and ethical boundaries and considers all outcome decisions (Anwar & Chandra, 2017). Management needs to review these options based on the current and future business and legal environment and ensure that the measures are intended for the benefit of the economic unit and stakeholders as a whole and that they are within legal and ethical limits. The management must maneuver within legal and ethical boundaries and refrain from adopting a strategy that can systematically impair the quality of financial statements and the treatment of accounting information. Members of the Board of Directors must thoroughly review strategies before they are adopted (Beneish, 2001). Income smoothing is not necessarily a harmful practice, but it is a logical result of the flexibility of the generally accepted accounting standards in the preparation and presentation of financial statements. Therefore, the management should, when choosing among the various accounting policies and implementing the practices available in the generally accepted accounting standards, make sure that it is within the legal and ethical limits. It achieves the interest of the economic unit and all relevant parties (Skinner & Soltes, 2011). From the previous, concluding that another element must be considered when applying income smoothing, which is the quality of earnings. The quality of earnings very essential when examining the relationship between income smoothing and company value. It may make sense for a firm to consider the quality of its earnings first before diluting its income because smoothing income with low quality seems irrational. Income smoothing is profitable only if the earnings are of high quality. Good management has the ability and skill to facilitate income without causing harm to any party, which means income smoothing is the intelligence of management (ASAOLU et al., 2021). 21 2.2 Previous Research After studying literature relating to income smoothing in general, it is important to discover the impacts of income smoothing on company value. Section (2.2.1) contain researches that have a positive impact on income smoothing on the company's value. Section (2.2.2) describes the negative impact of income smoothing on firm value. Previous studies indicate that using the change in earnings as a descriptor of income smoothing may not give a definitive answer to its impact on the value of the company. The possible remedy is also to look at the quality of earnings. The term of earnings quality has been widely used without a standard concept. However, the purpose of explaining the earnings summary is to enable investors and decision-makers to evaluate the source and potential repeatability of net income. Section (2.2.3) describes researches that have a positive impact on firm value. Next, the negative impact of earnings quality on firm value describes in section (2.2.4). 2.2.1 Income Smoothing Improve Firm Value This section discusses researches that indicates the existence of a positive impact of income smoothing on firm value. Susanto & Pradipta (2019) explore a significant positive relationship between company value measured (by P/E) ratio and income smoothing as measured (by the Eckel model). By applying among manufacturing companies in the Indonesia Stock Exchange from 2014 to 2016, they conclude that income smoothing practices enable the use of company information on a large scale which helps investors to predict future profits and lowering the risk associated with it. This makes it meet the needs of investors' interests and attractive to them, thus increasing the demand for its shares and raising their price, and consequently, the value of the company. Michelson et al. (2000) conduct another research to evaluate the association between income smoothing and return in the S&P 500; the Eckel model is used to detects income smoothing. They discover that firms that report smoother income have considerably greater cumulative abnormal returns than those that do not. As the standards of becoming an income smoother grow more difficult to meet, this conclusion becomes stronger. When the firms’ size consider, the anomalous returns become greater for smaller enterprises and weaker for bigger firms. 22 Shubita (2015) study the effect of income smoothing in the Saudi market from 1999- 2008, the results indicate that there is a positive impact of income smoothing on the earnings quality, which means that when a company smoothes its income, they show the ability to reflect firm future performance, and its ability to generate revenues. OBEIDAT (2021) find a positive and significant relationship between income smoothing and profitability of firms listed on the Amman Stock Exchange from 2010 to 2019. Where the study applies the Eckel model to reveal income smoothing practice, and ROE to measure profitability and total asset in determining the size of firms. They conclude that the companies try to retain their investors by engaging in income smoothing to meet the desire of investors about the return which will enhance them to invest in these companies. Tucker & Zarowin (2006) examine whether firms that smooth their income improve the informativeness of earnings from 1993 to 2000. They conclude that companies that smooth their income are more probability to impound their future earnings than lower smoothing firms, and the current price stock of these firms have high informative about their future earnings, which helps to analyze cash flow, accrual, future growth that helps to reduce future earnings fluctuation. If the managers use their discretion to communicate their prediction of future earnings they will improve their in formativeness. Sri KUSTONO et al (2021) investigate income smoothing practices in the Indonesian market, they use kustono (2011) to investigate income smoothing practices from 2013- 2019. They conclude that the manager uses the power of multiple-choice accounting to affect investors' views and decisions, where investor are more interested in companies with lower earnings fluctuation, these results add to the evidence that income smoothing is more concerned with its possibilities for generating earnings. 23 The research of Bitner and Dolan (1996) provides evidence for a favorable link between income smoothing and equities market value. They find several motivations to practice income smoothing which are connected to minimizing political costs, capital costs, and maximizing managers' remuneration schemes. Trueman and Titman (1988) emphasize that the company's managers will manage profitability to provide future debt holders with secure revenue streams. As a result, the needed return of the loan holders is reduced, resulting in a decreased cost of capital for the firm. 2.2.2 Income Smoothing Diminish Firm Value This section focus on the negative relationship between income smoothing and firm value. Abogun et al (2021) reveal a negative and significant impact of income smoothing as measured by Tucker and Zarown (2006) on firm value as measured by average share price and using market risk as a moderator in all listed firms on the Nigeria Stock Exchange from 2012 to 2018, they excluded the financial sectors. The study discovers that market risk significantly defines the relationship between income smoothing and firm value. When firms smooth income, their mean annualized return is much lower than when they do not smooth revenue. This conclusion becomes stronger when the standards of becoming an income smoother grow more challenging to meet. Smoothing companies have lower returns, reduced risk, and large size. Mohamad (2001) examine the effect of income smoothing in the Malaysian market by using a sample of 231 companies from 1990 to 1998. The study applies the Eckel model to reveal the income smoothing practice, and the P/E ratio to measure profitability. The study finds that the companies with higher earnings and a greater level of debt have a lower tendency to smooth their income, this indicates that the managers have high motivation to smooth income during the economic crises period to control fluctuation in reported income Michelson et al., (1995) examine a sample of 358 firms in the S&P 500. In measuring the performance in the marketplace, he used data that contained stock price, return for each stock, and the total number of outstanding shares. The study reveals that smoothing companies have lower annual returns than companies which do not smooth. They also find that smoothing companies have lower beta, which means that income 24 smoothing decrease the actual or perceived risk of the company, which leads to decreased returns for that investor in the lower risk company. Nurdiansyah et al., (2021) apply a study on companies listed on the Indonesia stock exchange from 2015 to 2017. The results showed a negative and significant impact on profitability as measured by ROA and income smoothing, which means lower profitability is not attracting investors' attention. 2.2.3 Earnings Quality Improve Firm Value Saleh et al., (2020) explore the earnings quality effect of companies' performance, using a sample of Jordanian companies from 2010 to 2018, the result indicates that earnings quality positively affects ROE, which means that good management behavior will lead to an increase in firm performance and will lead to high decision maker protection, where the information seems less ambiguity, this will help to capture useful information. DANG et al., (2020) examine the effect of earnings quality on the value of firms listed on the Vietnam Stock Exchange within the period from 2010 to 2018. They reveal that earnings quality as measured by persistence, earnings management, and timeliness positively affect Tobin's Q, which means that the accounting system is generally able to reflect the economic value of the firms valued by the market. Annes & Domingos (2016) examine the relationship between earnings quality and firm performance in the Lisbon stock exchange from 1987 to 2016. They reveal that persistence only statistically affected the company value, which is considered a good item, and is desirable by an investor to capture profit sustainability. Bao and Bao (2004) research this issue differently to examine the influence of income smoothing on company value, they introduce earnings quality as an explanatory variable. They conclude that companies with high earnings quality outperform firms with low earnings quality. As a result, the quality of earnings appears to have a favorable impact on company value. 25 2.2.4 Earnings Quality Diminish Firm Value Hutagaol‐Martowidjojo et al., (2019) explore the relationship between earnings quality and Tobin's Q as the mean of company value from 1995 to 2015. The finding indicates a negative effect on the Indonesian stock market. Quality standards decline over time and companies that pay dividends and have high-risk stocks are evaluated as a high value. Following the international Financial Reporting and standards (IFRS) does not automatically lead to an increase in the quality of the reporting process. The dividends take the role of evaluation rather than the quality of earnings.. Latif et al., (2017) explore a negative relationship between smoothing and persistence with Tobin's Q of non-financial Pakistan company within the period 2003-2014, where both are considered managerial opportunistic toward the alternative of accounting standard. All earnings attributes (predictability, accrual, value relevance) positively impact Tobin's Q, where the increase in EQ attributes leads to decreasing information asymmetry and incorrect reporting to the stakeholder. Because of a reduction in information risk, stakeholders are more confident in purchasing such companies’ stock driving up the firm market value. 2.2.5 The Association between Earnings Quality and Income Smoothing on Firm Value Based on the above arguments, it is reasonable to conclude that when analyzing the link between income smoothing and firm value, earnings quality is critical. Before smoothing results, a corporation should assess the quality of its earnings, because smoothing earnings with low quality looks to make little sense. Income smoothing is beneficial to corporate value only if the earnings are of high quality (Bao & Bao,2004). 2.3 Conceptual Model Figure (1) presents the conceptual framework of the study, where the elements of the study are articulated 26 Figure (1) Conceptual Model 2.4 Hypothesis Development H1: There is a significant relationship between income smoothing and the value of companies listed on the Palestine Exchange (PEX). H2: There is a significant relationship between accruals quality and the value of companies listed on the Palestine Exchange (PEX). H3: There is a significant relationship between persistence of earnings and the value of companies listed on the Palestine Exchange (PEX). H4: There is a significant relationship between timeliness of earnings and the value of companies listed on the Palestine Exchange (PEX). Control Variable Company Size Financial Leverage Growth Beta Dependent Variable Tobin’s Q ROE Independent Variables Income Smoothing Accruals Quality Persistence of Earnings Timeliness of Earnings Dummy Variable Industry 1 Industry 2 27 Chapter Three Methodology 3.1 Population and Sample The population of this thesis includes all the listed companies in Palestine Exchange which are 48 companies as of December 2019. Except financial companies(Banks and Insurance). These companies have been excluded because they have their accounting system and different evaluation tools (Etemadi & Sepasi,2008). The sample of the thesis includes (30) publicly listed companies across three sectors namely: services, industry, and investment. Appendix (A) highlights publicly listed company across three sectors Table (1) illustrates the distribution of the sample across the sectors, The service sector has the largest market capitalization among the sectors. Followed by the investment and industry sectors. Table (1) Market Capitalization ( as of December 2019) Across Sectors Sector NO. Market Capitalization($) Percentage Services 9 1,208,616,406 50.37% Industry 12 395,646,434 16.49% Investment 9 795,044,644 33.14% Total 30 2399307484 100% 3.2. Data Collection Secondary data are gathered from the financial statements of the sample posted on the Palestine Exchange (PEX) website. The sample period extends from (2010-2019). The years 2020 and 2021 were not included because the researcher's goal is to show results without the impact of Covid-19 3.3 Econometric Model The collected data are analyzed using the FGLS Panel regression method, and utilizing the STATA program. Two models have been estimated to answer the research question as follows. 28 Tobin's Q= ���� + �� �� + ��� �� + ����� + �� ��� + �� ��� + ������ + ����� + ����� + ������ + ������� + ��� ROE= ���� + �� �� + ��� �� + ����� + �� ��� + �� ��� + ������ + ����� + ����� + ������ + ������� + ��� 3.4 Variables of the study Appendix (C) shows the variables and measurements used in this thesis. 3.4.1 Dependent Variables Company Value Company value is defined as the total value of outstanding shares in the financial market (Merz & Yashiv, 2007). There are various measures available to gauge the value of a company. Tobin's Q and ROE are used as valuation criteria. It's worth mentioning that the only stock issued on Palestine Exchange is common stock. 1. Tobin’s Q This measure plays an important role in many financial interactions. It was created in 1966 as an empirical measure of financial market and macroeconomic investment analysis. Tobin’s Q is defined as a firm's market value to the replacement cost of the valuation of its assets. On the other hand, its a means of estimating whether a given business is overvalued or undervalued (Chung& Pruitt, 1994). La Porta et al., (2000) indicate that the market value can significantly affect the company's real value if giving enough relevant information. James Tobin constructed the (TQ) value used in this research. Tobin’s Q = (�� !"# $�%&" '( ")&*#+,-''! $�%&" '( ."-#) 0''! $�%&" '( #'#�% �11"#1 Where: Market value of equity =number of shares outstanding×market price per share. Book value of debt= the value of long-term debt+ short- term debts. Book value of assets = the value of total assets in the financial reports of the company. 29 2. ROE This measure is to reveals the profitability of a business in relation to the equity, used for comparing the performance of the business in the same industry. Return on equity is the total return on equity capital and is a criterion that shows a company's ability to turn equity investments into profits. Return on equity is expressed as a percentage and is calculated by dividing net income by average total equity (Hejazi et al.,2011). It can be calculated by the formula as follows: 234*# = 5"# 678'9" *.# ;$" �<" ='#�% >)&*#+ Where : 234*#: return on equity for company (i) for the year(t). Net income it : net income for the company (i) for the year(t). Average total equity: (total equity at the beginning year+ total equity at the end of year)/2 3.4.2 Independent Variables A. Income Smoothing The coefficient of variation approach developed by Eckel(1981) is used in this research to identify the presence of income smoothing. As is commonly assumed, changes in sales are the results of real smoothing while changes in income are the results of artificial smoothing, thus the study used real sales and income. Futher, Eckel uses the index term df to measure income smoothing. A company is given a value of 1 if its income is smoother and a value of 0 it's not (Susanto & Pradipta, 2019). Eckel model developed this model based on a set of assumptions, including income is a linear function of sales, income smoothing can be paved by real boots and cannot be paved by artificial boots, and the variable cost ratio to sales is in constant currency unit, and fixed costs remain constant or increase and are not likely to decrease (Amina, 2018). According to Eckel model 1981 the value of smoothing coefficient is founds as follows: 30 df = ?@∆ B ?@∆ C where : df = The index of income smoothing cv∆D = The coefficient of variation for changes in net income. cv∆s = The coefficient of variation for changes in revenue/sales.(total sales from the income statement of the company). The value of cv∆D EFG HI∆J is calculated as follows: =√( ∑ ∆MN∆M 7NO ) Where ∆x= change in net income(I) or sales (S). ∆‾x = Average change in net income (I) or sales (S). n = The number of years when the value of df is less than 1, the income smoothing has been done. Otherwise, it has not been done. B. Earnings Quality Refers to the ability of reported earnings (or income)to predict future earnings for the company, and is an important criterion for assessing the persistency, controllability, and deductibility of a company's earnings, broadly defined as the degree to which earnings reflect underlying economic effects, and are best in estimating cash flows, or predictable. Taking into account all of these definitions, the study could have different approaches to earnings quality ( Schipper & Vincent, 2003). i) Accrual Quality According to Al-Ani and Chong (2021), the accrual quality can be defined as the difference between current earnings and operating cash flow divided by average total 31 assets. The management uses its accounting estimates to hide economic shocks in the company, speed up the recognition of profits, or delay recognition of current losses to conceal a current poor performance or conceal a strong current performance(Leuz et al .,2003). The larger the accounting accruals, the greater the uncertainty and estimate error due to probable estimation mistakes. Thus, measuring the accrual quality by following using a formula used by Richardson (2003). Accrual Quality= (>� 7*7 chi2 0.031 Akaike crit. (AIC) 166.551 *** p<.01, ** p<.05, * p<.1 Source: Stata output 40 4.4.2 Second MODEL (ROE) The second model examines the impact of earnings quality and income smoothing on the valuation of companies using ROE as a dependent variable. The results of the following model are below in table (5). ROEit=���� + �� �� + ��� �� + ����� + �� ��� + �� ��� + ������ + ����� + ����� + ������ + ������� + ��� A. Earnings Quality and ROE Ratio Table (5) shows persistence (PS) has a positive impact on companies’ value as measured by (ROE), but this impact is insignificant. However, the accrual (ACC) shows a positive and significant impact on ROE where regression coefficient (.384). The results show the negative and significant impact of timeliness (T) on ROE with a regression coefficient (.059). B. Smoothing and ROE Ratio Table (5) shows that smoothing (SM) has a significant positive effect on the value of the company (.035). C. Control Variables and ROE Ratio Table (5) shows a positive and significant impact of size (SI) on ROE where regression coefficient (.015). On the other hand, Financial leverage(LV) shows a negative and significant impact on ROE shows with regression coefficient (-.068). Concerning to the effect of growth(G) and firm value, the result shows an insignificant and negative impact. 41 Table (5) ROE- FGLS ROE Coef. St.Err. t- value p-value [95% Conf Interval] Sig PS 0 0 0.75 0.451 0 0.001 ACC 0.384 0.057 6.74 0 0.272 0.495 *** T -0.059 0.019 -3.14 0.002 -0.096 -0.022 *** SM 0.035 0.014 2.58 0.01 0.008 0.061 *** SI 0.015 0.004 3.47 0.001 0.006 0.023 *** LV -0.068 0.011 -6 0 -0.09 -0.046 *** G 0 0.001 0.73 0.468 -0.001 0.001 B -0.008 0.006 -1.39 0.166 -0.019 0.003 I 1 0.02 0.015 1.28 0.2 -0.01 0.05 I 2 0.058 0.014 4.07 0 0.03 0.086 *** Constant -0.182 0.075 -2.42 0.015 -0.329 -0.035 ** Mean dependent var 0.033 SD dependent var 0.119 Number of obs 300 Chi- square 183.425 Prob > chi2 0.022 Akaike crit. (AIC) -547.95 *** p<.01, ** p<.05, * p<.1 Source: stata output 4.5 Diagnostic Test Several diagnostic checks have been performed on the estimated models include: 4.5.1 Variance Inflation Factor (VIF) Table (6) presents the VIF between the independent variables of the study which (SI, d, G, ACC, T, LV, PS and SM) have values of (1.491,1.29,1.18,1.105,1.271,1.271,1.98 and 1.029), respectively. These values are less than 5, which indicates that there is no multicollinearity problem between variables in the model. 42 Table (6) Variance Inflation Factor (VIF) VIF 1/VIF PS 1.032 0.969 ACC 1.145 0.873 T 1.119 0.893 SM 1.328 0.753 SI 1.501 0.666 LV 1.226 0.816 G 1.115 0.897 B 1.219 0.82 1.I1 1.708 0.586 1.I2 1.676 0.597 Mean VIF 1.307 . Source: Stata Output 4.5.2 Heteroscedasticity Test 4.5.2.1 Model 1: TQ ratio Homoscedasticity is tested using the white test, where the null hypothesis there is no hertoscedasticity in the residual and that the residual is homoscedasticity. The results are chi2(61) = 244.96, Prob > chi2 = 0.0000.Cameron & Trivedi's decomposition of IM- test. Therefore, If p-value is less than 5%, thus cannot reject the null hypotheses, which means that the problem of heteroscedasticity exists, table (7) express the white test . Table (7) TQ- White's test Source chi2 df P Heteroskedasticity 244.96 61.00 0.00 Skewness 61.23 10.00 0.00 Kurtosis 6.86 1.00 0.01 Total 313.05 72.00 0.00 4.5.2.2 Model 2: ROE Ratio chi2(61) = 221.36 the Prob > chi2 = 0.0000, If the p-value is less than 5%, thus cannot reject the null hypotheses, which means the problem of heteroscedasticity exists. 43 Table (8) ROE- White's test Source chi2 df P Heteroskedasticity 221.36 61.00 0.00 Skewness 33.40 10.00 0.00 Kurtosis 2.64 1.00 0.10 Total 257.40 72.00 0.00 4.5.3 Autocorrelation Test Wooldridge test for autocorrelation in panel data tests the following null (H0) versus the alternative hypothesis (H1) as follows: H0: no first-order autocorrelation H1: there is first-order autocorrelation In model 1, the results comes out as; F (1,29) = 2.336, and Prob > F = 0.1372 is more than 0.05, which means accept the null hypothesis . Therefore, concluding that there is no firs order autocorrelation between the residuals in the model. However, in model 2, thus, reject the null hypothesis as F (1,29) = 6.129, and Prob > F = 0.0194 is less than 0.05. Therefore, concluding that there is an autocorrelation between the residuals in the model. 44 Chapter Five Conclusion and Recommendation 5.1 Introduction This thesis aims to study the impact of the earnings quality and income smoothing on the valuations of companies listed on the Palestine exchange by using the data in the financial statements from 2010 to 2019. FGLS regression is employed to identify this impact on the value of companies using data with 300 observations. 5.2 Results 5.2.1 Earnings Quality on the Value of Company There is a negative and significant impact of earnings quality as measured by timeliness (T) on firm value as measured by Tobin’s Q (TQ) and ROE, this result can be explained by the possibility of leakage information before being published to the public. Accordingly, when information is realized in the market its full effect is being incorporated into the market price. This indicates a reversal effect which highlights the market inefficiency, this result supported by (Alkhatib & Harasheh, 2014) and (Shihadeh & Hannon, 2016), thus the result are consistent with the third hypothesis. This research discovers a positive and significant effect of earnings quality as measured by accrual (ACC) on company value as measured by ROE. Earnings consist of two components (accruals and operating cash flow). Higher accruals relative to cash flow is a signal for earnings management. Because investors fail to evaluate operating cash flow information in earnings, they tend to be more optimistic about the likelihood of high-earning companies and more pessimistic about low-earning companies (Sulistiawan & Rudiawarni, 2017), therefore, the result are consistent with second hypothesis. Nichols & Wahlen (2004) provide evidence that accruals generate less risk for stocks, thus managing earnings through accruals reduces stock risks. The stock market reacts positively to earnings discretion, because the discretions facilitate the recognition of gains and losses promptly. Since management discretionary behaviors through accruals increase earnings persistence, and low information risk and thus constitutes an incentive for the investor, which raises the demand for shares, and 45 improve the ability of current earnings in signaling future firm’s prospect, this result is confirmed (Ball et al.,2015) and (Sun & Rath, 2008). In addition, Dechow & Schrand (2004) demonstrate that the interest in improving the quality of that future information used in forecasting, its accuracy, and proximity to reality will inevitably reflect positively on the effectiveness of investment decisions, which leads to more flow of funds into the market from all possible sources, support the capital market, encourage and attract investment. These findings support investors and investment managers by enabling them to use accruals information as a trading strategy to reduce their risk and increase their returns. 5.2.2 Income Smoothing on the Value of Company According to the research, income smoothing (SM) has a favorable and significant influence on company value as assessed by ROE. This finding backs up the findings of (Sri KUSTONO et al., 2021), (Susanto & Pradipta (2019), and (Dewi et al., 2018), which show that companies have a direct impact on the purchasing behavior of current investors because investors are long-term stakeholders who care about the current performance of companies and are interested in the element of sustainability. They base their investment decisions solely on annual income. This is in line with what Zarowin (2002) stated, namely, that income smoothing improves the accounting information in the report and substantially impacts the current investor's decision because it is the primary source of information used by investors. The correlation is that income smoothing increases dividend payments while maintaining a minimum rate of return, lowering the cost of capital. Because the stability of the income stream increases users' confidence in the company, they tend to convey information about the company's ability to earn future profits through the income stream. Providing income information for the current period is more valuable in predicting future profits, which reduces information risks. As a result, it aligns with investors' intere