Accounting and Finance 39 (1999) 229 ± 254

Political cost influences on income smoothing via

extraordinary item classification

Jayne M. Godfreya, Kerrie L. Jonesb

a
School of Accounting and Finance, University of Tasmania, Tasmania 7005
b Foster's Brewing Group Ltd, Southbank, Victoria 3006

Abstract

Until 1990, Australian managers could classify recurring gains and losses
outside the normal operations of the firm as either operating or extraordinary
items. The results of this study indicate that managers of companies with
highly unionised workforces, and therefore subject to labour-related political
costs, attempted to affect the probability of wealth transfers by smoothing
reported net operating profit via the classification of those recurring gains and
losses. The degree of management ownership is associated with classificatory
smoothing but interest coverage is not, indicating differential contracting
influences.

Key words: Political costs; Income smoothing; Classificatory smoothing;

Extraordinary items

JEL classification: M41; C21; 023

1. Introduction

In this paper we examine whether opportunities for politically driven wealth

transfers are associated with income smoothing via Australian managers'
classifications of recurring gains and losses as extraordinary or operating items
in 1988 ± 1989. We find that managers potentially used classificatory smoothing
to reduce political costs, an issue not previously investigated in the financial
accounting literature. This finding assists in understanding how accounting
classification can affect wealth distributions. A secondary focus of the paper is

This paper has benefited from comments by Jilnaught Wong (the Editor), the
anonymous referees, Jerry Bowman, Michael Bradbury, Geoff Burrows, Jane Culvenor,
David Emanuel, Christine Jubb, Donald Stokes, Julie Walker, Ron Weber, Cynthia
Wilson, Victoria Wise, Ian Zimmer, and participants at workshops at LA Trobe
University and the Universities of Auckland, Melbourne, Queensland, and Southern
Queensland.

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to determine whether traditional contracting incentives are associated with

classificatory smoothing.
Consistent with prior studies (Barnea, Ronen and Sadan, 1975; Moses,
1987), we expect operating profit, calculated as consolidated profit after tax
and minority interests and before extraordinary items, to be the income
smoothing target. We assume that managers are influenced by their
perceptions of various financial statement users' earnings expectations which,
in turn, are influenced by prior operating profits. The Australian Securities
Industry Commission focuses on operating profits (Parker, 1993), and Jones
(1991, p. 197) notes in relation to the use of earnings figures by regulators that
`An analysis of the income statement through net operating profit (or loss)
before taxes for the industry is always presented'.1 Capital market studies such
as Kormendi and Lipe (1987) use earnings measures before extraordinary items
in assessing the information content of reported earnings, and studies finding
positive associations between earnings response coefficients (ERCs) and
earnings persistence focus upon earnings before extraordinary items because
`Extraordinary items are, by definition, unlikely to persist ...' (Brown, 1994,
p. 39). Also, considerable anecdotal evidence indicates that reactions to annual
report profit figures by trade union officials, spokespersons for community
pressure groups and non-financial journalists focus on operating profit.2
Prior studies conclude that US managers classify items as `operating' or
`extraordinary' to dampen fluctuations of operating income (e.g., Barnea,
Ronen and Sadan, 1975). While US requirements have always required
extraordinary gains and losses to be non-recurring, Australian accounting
standards imposed the same requirement only from 1989. As such, the
Australian reporting environment provides a rich opportunity to examine the
motivation for any classificatory smoothing via extraordinary items. While
Hoffman and Zimmer (1994) find that Australian managers selectively classify
recurring items, they focus on whether the classification increased or decreased
operating profit. We extend their research to management's attempts to

1
We focus on after tax operating profits because they are arguably a better indicator of
firms' ability to increase returns to various stakeholders such as customers=society in
general, employees or shareholders (see section 2). Smoothing pre-tax operating profits
generally smooths post-tax operating profits also.
2
For example, Jobson's Year Book of Public Companies reports operating profit and the
Australian Financial Review generally gives primacy to reporting operating profit and
then states the extraordinary profit or loss figure. Where discussed at all, extraordinary
items usually appear in the last quarter of any article. For example, see Clyde doubles
profit, 29=8=1989, p. 20; Writedowns put paid to Forsyth profit, 21=4=1989, p. 34; Lend
Lease at a glance, 1=9=1989, p. 26; Boral unfazed by high rates, 5=9=1989, pp. 1 ± 2; FAI
battered by rain, writedowns, 5=9=1989, p. 18; WMC doubles pre-tax profit, 8=9=1989,

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pp. 11 ± 12. In The Australian articles citing casinos' lobbying for reduced super taxes on
revenue from international gamblers, cite casino operating losses and profit declines
(Harris, 21=1=1998, p. 5; Magazanik, 21=1=1998, p. 1).

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smooth operating profit (either in addition to or instead of earnings level

management). Craig and Walsh (1989) find that Australian managers smooth
profits, but they examine profits after extraordinary items rather than
operating profits.
We propose that firms smooth reported operating profits as a plausible and
sustainable earnings management strategy to minimise the likelihood of
adverse political attention. As a short-term strategy for periods of particularly
high political cost exposure, firms facing these costs can use income reducing
techniques to avert adverse public, legislative, or other political attention (see
Watts and Zimmerman, 1978; Wong, 1988; Cahan, 1992). However, this
approach is unsustainable in a multi-period setting where accruals reverse, but
firms maintain their exposure to political costs. Income smoothing averts
attention from `excessive' high earnings that might be argued to reflect the
exploitation of consumers or employees. It also avoids concerns which arise
from low reported operating profits, such as from investors seeking dividends,
lenders concerned about loan security, employees concerned about future
employment prospects, suppliers and customers assessing future stability, or
governments investigating unviable industries.3 It is a rational multi-period
response to the costs that firms can face due to earnings volatility.
Like Hoffman and Zimmer (1994), we take advantage of a unique
opportunity to observe the regulatory impact on firms' classification of items
as extraordinary and to assess cross-sectional variation in their voluntary
classification of recurring items. Prior to 1989, Australian regulations defined
extraordinary items as gains or losses outside the firm's ordinary operations
(AASB, 1989). Flexibility in determining what constitutes `ordinary opera-
tions' allowed managers to manipulate operating profits. Consequently, firms
were sometimes criticised for manipulating operating profits by treating
recurring items as extraordinary.4 To reduce the potential for opportunistic
behaviour, the Accounting Standards Review Board (ASRB) gave interim
approval to the mandatory accounting standard ASRB 1018 Profit and Loss

3
For example, Jones (1991, p. 202) notes that `The ITC normally requests information
for five years prior to the date the petition was filed for general escape clause cases ...'.
This demonstrates where a multiperiod focus could require smoothing to dampen intra-
(multiple)-period profit peaks, or transfer early profit troughs so that an upwards
earnings trend is not perceived by regulators.
4
For example, Bond Corporation was criticised by the National Companies and
Securities Commission for treating recurring losses on the sale of investments=
businesses as extraordinary (Australian Financial Review, 6 March 1985 p. 52). This
classification is claimed to have `saved Bond Corporation from disaster more than once'

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(Australian Financial Review, 14 March 1985 p. 52). Of 29 firms randomly selected from
our test sample of 58 companies, 24 of the 26 firms reporting extraordinary items during
1985 ± 1988 classified recurring items as extraordinary.

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Accounts (now AASB 1018) in 1989. The definition of extraordinary items was
modified to:

... items of revenue and expense which are attributable to events or transactions of a
type that are outside the ordinary operations of the reporting entity and are not of a
recurring nature (para. 7) (emphasis added).

The amendment applied from 1990 but the Corporations Law (s. 300 (1))
required that 1989 comparative accounts included with the 1990 financial
statements comply with the revised extraordinary items definition. Comparison
of these restated figures with those reported in 1989 indicates how the financial
statements would have differed in 1989 if the standard then required
extraordinary items to be non-recurring.
The remainder of the paper is organised as follows: Section 2 develops the
main hypotheses, Section 3 describes other plausible costly contracting
predictions, Section 4 describes the research design, and Section 5 reports
the results. Section 6 summarises and concludes the study.

2. Hypothesis development

The weight of evidence indicates that large firms use discretionary

accounting policy choices to reduce reported earnings (Watts and Zimmerman,
1978; Hagerman and Zmijewski, 1979; Bowen, Noreen and Lacey, 1981;
Dhaliwal, 1988). Firm size is generally used to proxy for political cost
exposure, although size is also highly correlated with industry. Hence, it is
possible that the income decreasing incentives are industry-based rather than
firm-specific (see Bowen et al., 1981 and Watts and Zimmerman, 1978 where
results are consistent with oil and gas industry driven effects). Such an
interpretation is consistent with earnings management studies focusing on
industry-based incentives to manage earnings to influence regulation related to
industry taxes or industry protection (e.g., Jones, 1991). In this study, we use a
sample with broad industry representation and use alternative measures of
expected political costs to examine firm-specific reporting incentives.
Instead of reducing reported income, managers can reduce the likelihood of
adverse responses to levels of profits by income smoothing (Watts and
Zimmerman, 1986, p. 223). Smoothing reduces the likelihood that large
increases in income will attract public scrutiny. It also reduces the potential for
the firm's cost of capital to increase due to the inherent risk in income.
Managers can choose from a range of smoothing techniques, including
classificatory smoothing, accounting policy choices, and the timing of
transactions. If classificatory smoothing is less costly than its alternatives,

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managers will adopt it either instead of, or in addition to, other smoothing
devices. Prior to 1990, classificatory smoothing in relation to recurring gains
and losses outside firms' normal operations was low cost, since it was not

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necessary to reveal the effects of changes in classification of items on operating

profit. In contrast, firms are required to reveal the financial statement effects of
changes in accounting methods (AASB, 1985, para. 40).

2.1. Industry concentration

Market share, or an industry concentration ratio, is often used to proxy for

the ability of a firm to earn monopoly rents and its exposure to political costs
such as the removal of tariff or subsidy protection (Hagerman and Zmijewski,
1979; Wong, 1988; Jones, 1991). Firms lobbying government in particular
years cite falling operating profits in media releases (Lenthall, 1995). Hence, in
those particular years their managers are likely to manage reported earnings
downwards.
However, in a multi-period setting where political cost exposure is associated
with potential monopoly rents, managers of firms in industries with high
market concentration have incentives to smooth income. The incentive to
smooth rather than depress reported earnings arises because managers in
industries with high market concentration seek not only to avert regulatory
attention to high profits, but also to maintain favourable relations with
suppliers, customers and employees who provide their competitive edge.
Avoiding profit `troughs' mitigates these parties' concerns about instability and
loss of market share; concerns that could otherwise cause them to develop
alternative strategic alliances and to take their supply, custom or labour
elsewhere, or to charge more for the perceived increased risk. While the
incentive to avoid earnings' troughs is not necessarily applicable only to highly
concentrated industries, the fact that it applies to them, along with their
particular incentives to avoid reporting earnings peaks, means that they have
greater smoothing incentives than firms that operate in less concentrated
industries.

H1: Firms that smoothed operating profits via the discretionary classification of
recurring gains and losses as extraordinary items belonged to industries with
higher market concentration than firms that did not smooth operating profits via
discretionary classification of recurring gains and losses as extraordinary items.

2.2. Employee costs

One of the most important factors affecting wage determination is the firm's
ability to pay higher wages. This can be estimated by using past financial
information or financial forecasts (Horwitz and Shebahang, 1971). For
example, Christofides and Oswald (1992) find that employees' real wages are

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an increasing function of the past profitability of the firm. When Moses (1987)
examines the association between income smoothing and the degree of union
membership, he predicts that sharp increases in a company's earnings generate

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demands for wage increases by unions and that sharp decreases have adverse
labour effects such as low employee morale, consequential productivity
decreases, and decreased retention rates as employees seek increased job
stability or improved conditions.
Unionisation is likely to facilitate the dissemination of information
contained in financial statements amongst employees, and collective action
to demand wage increases or other improved employment conditions is more
likely where unions are involved.5 The argument for smoothing rather than
minimising income relies upon the assumption that management is concerned
about potential reporting effects on morale and productivity, and therefore
on labour cost through either wage levels or productivity. We argue that
demands for increased wages are not a likely consequence of increased
employee morale due to income being smoothed upwards, in contrast to
income peaking upwards. Rather, smoothed income allays concerns
about firm profitability (and employee tenure) while not unduly raising
expectations.
While Moses' prediction is not supported by US evidence, it is possible that
the extent of union membership and the economic circumstances of the time,
influenced Australian firms' classification of recurring items as operating or
extraordinary. This is particularly the case for reporting practices in 1989,
when company profitability peaked (Australian Bureau of Statistics, 1997a),6
wages growth was restrained relative to corporate profitability (Australian
Bureau of Statistics, 1997a and 1997b), and unemployment had been falling for
almost a decade. During 1989, enterprise bargaining was gathering momen-
tum7 and there was heightened interest in the relativity of wages to profits.
Thus, we predict firms had an incentive to smooth profits (a) downwards to
dampen demand for higher wages if profitability was increasing more than

5
These earnings issues were raised in relation to Qantas earnings in the late 1980s,
resulting in a profit-sharing scheme involving tradespeople. The Australian Council of
Trade Unions played a key role in these developments and is credited as having `scored
a breakthrough in wages flexibility ...'. The deal struck with Qantas was described as
`part of a strategy aimed at stemming the exodus of people from the airline' (see
Williams, 1989).
6
During 1989, corporate profitability was at its highest in the decade from the early
1980s, until the mid 1990s (Australian Bureau of Statistics, 1997a).
7
Gardner and Palmer (1992, p. 37) comment in relation to enterprise bargaining in
Australia: `The period from 1975 to the 1990s was characterised by the greater
integration of unions and government policy and as a consequence the movement of

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industrial relations to the centre of government social and economic policy. By the end
of the period the drive to an enterprise focus had gathered momentum, changing the
policy directions of unions, employers, government and arbitral tribunals.'

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expected, and (b) upwards to stimulate morale for firms whose profitability
was not increasing as expected.

H2: Firms that smoothed operating profit via the discretionary classification of
recurring gains or losses as extraordinary items had higher union membership
than firms that did not smooth operating profit via the discretionary classification
of recurring gains or losses as extraordinary items.

2.3. Executive remuneration

Managerial remuneration that appears to be disproportionately high relative

to firm performance is likely to be queried by shareholders or within the
financial press.8 If executive remuneration is perceived as being excessive,
shareholders may lobby for future remuneration to be set at a lower level, or at
least to increase at a slower rate. Alternatively, an executive could be removed
from office if the remuneration is deemed to be opportunistic. Such reactions
are detrimental to the reputations of the firms as well as the managers.
In developing a theory that suggests concerns about job security create
incentives for managers to smooth earnings for assessments of both current
and future performance, Fudenberg and Tirole (1995) assume that poor
current performance increases the probability of dismissal while good current
period performance does not compensate for future poor performance. The
implication is that managers will `borrow' earnings from good years and `lend'
to poorer years to smooth earnings. DeFond and Park (1997) find empirical
support for this theory.
Managers can mitigate these effects by smoothing operating earnings.
However, Hoffman and Zimmer (1994) find weak evidence that managers tend
to classify recurring gains rather than recurring losses as operating items more
as the ratio of chief executive remuneration to firm earnings increases. This
implies that where executive remuneration is high, managers employ
classificatory income increasing techniques. But it may not always be in
managers' interests to maximise operating earnings. If managerial performance
is either directly or indirectly assessed in relation to a time series of operating
profit, then managers will prefer a smooth income stream. Shareholders are

8
A feature article in the financial press that surveys and reports individual executives'
salaries is an example of the attention disproportionate salaries can receive: `... CEO
salary levels might better reflect their negotiating skills than their value to the
organisations they lead. ... Australia's investment community ... do (es) not mind the big
salaries if they are matched with strong growth in earnings per share, but resent big
packages when the returns are not there ... It is the big cash salaries that institutional
investors have a problem with.' (Ferguson, 1997) It is not only high salaries relative to

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earnings that attract attention: `... if a successful chief executive is receiving an

uncompetitive package, shareholders should be asking hard questions of the board
about just how it plans to keep the head hunters away' (Ibid, p. 61).

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more likely to accept high executive remuneration if it can be seen that firms
have stable but steadily increasing incomes, and stable earnings trends are
likely to enhance job security. Thus, managers who smooth income probably
limit their exposure to criticism related to their level of remuneration, or the
tenure of their position. Further, maintaining smooth earnings trends can
mitigate against revisions of compensation plan thresholds where they apply.
The significance of these issues to managers' incentives increases as the
proportion of operating profits paid to executives increases.
The preceding arguments imply:

H3: Firms that smoothed operating profits via the discretionary classification of
recurring gains or losses as extraordinary items had higher ratios of reported
executive remuneration to operating earnings before extraordinary items than
firms that did not smooth operating profits via the discretionary classification of
recurring gains or losses as extraordinary items.

Mitigating this effect is the fact that managers in high-risk industries are
likely to be paid higher salaries than managers in other industries, but they
do not necessarily have the same smoothing incentives. The only remunera-
tion clearly reported in Australian financial statements relates to salaries. 9
The higher the systematic risk faced by management, the greater is the
proportion of management remuneration that is likely to be paid as straight
salary in order to reduce the uncontrollable compensation risk faced by
management (Lewellen, Loderer and Martin, 1987, pp 292 ± 293). If
managers in high risk firms have incentives to signal the variability of
earnings and the possibility of high returns, a counter-effect to the
hypothesised motivation for smoothing occurs and biases against finding a
result supporting H3.

3. Other incentives for classificatory smoothing

We also investigate whether variations on the bonus hypothesis and

debt hypothesis can explain the incidence of classificatory smoothing.
The bonus hypothesis is difficult to test because Australian firms do not
disclose management compensation plans. Nonetheless, it can be tested
indirectly.

9
The poor disclosures of executive remuneration by most firms are lamentable, and
prevent the conduct of much management compensation based research. In the context
of this study, however, the political cost issue is one of perception rather than fact:

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Management has incentives to reduce the apparent percentage of profit paid to them. As
such, it is appropriate to base tests upon disclosed information, despite its inadequacies
for other purposes.

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Managers with small levels of ownership have incentives to manage

operating profit upwards in a single period model because they bear little of
the cost of wealth transfers from shareholders to management (Jensen and
Meckling, 1976). In a multiperiod context, managers of firms with dispersed
ownership are likely to smooth reported operating earnings to avoid the
revisions to their compensation plans that may arise from excessive profit-
ability. Similarly, even in the absence of explicit earnings-based management
compensation plans, managers of firms with dispersed ownership control are
likely to smooth reported earnings to ensure they meet earnings expectations
that have been revised on the basis of prior period earnings peaks.
Consequently, we predict that firms that smoothed operating profits via
discretionary classification of recurring gains or losses as extraordinary items
had less ownership concentrated in the hands of a single shareholder than firms
that did not smooth operating profits via discretionary classification of recurring
gains or losses as extraordinary items.
The role of debt contracts in the management of income is also well
documented (Press and Weintrop, 1990; Leftwich, 1981; Holthausen, 1981).
While leverage constraints are unaffected by the definition of extraordinary
items, extraordinary items can affect interest coverage, a constraint which is
often computed by dividing operating profit by interest paid (Whittred and
Zimmer, 1986). In a multiperiod context, managers are likely to smooth
operating profit to avoid fluctuations that may cause a breach of the
ratio. Alternatively, they may use classificatory smoothing to create an
impression of financial stability and ability to meet interest commitments,
regardless of the presence of an interest coverage constraint. However, it is
to be expected that the lower the firm's interest coverage in any given period,
the more managers will classify extraordinary items to ensure they meet
their covenant constraints. This involves income-increasing classification
rather than classificatory smoothing if managers adopt a single period
perspective.
Given that corporate profitability was high in the late 1980s, we adopt a
multi-period perspective and predict that firms that smoothed operating profits
via discretionary classification of recurring gains or losses as extraordinary
items had lower interest coverage than firms that did not smooth operating
profits via discretionary classification of recurring gains or losses as
extraordinary items.

4. Method

4.1. Operationalisation of constructs

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The hypotheses are tested using the following proxy measures:

Industry concentration Industry concentration is proxied by the log10 of the
firms' Herfindahl Index (CONC), measured as the sum of the squares of the

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market shares of the largest four firms in the industry.10,11 Market shares are
calculated relative to total sales except in industries where this is not a common
measure of size or market share (Finance, Investment and Insurance industries
in the case of this study), in which case market share is calculated relative to
total assets. The higher the measure, the greater the market concentration.
It could be argued that a more appropriate measure of political costs
associated with industry concentration would be an interaction of firm size with
the industry Herfindahl Index, since the larger a firm within its industry, the
greater the political costs it faces. However, in the context of the sample used in
this study, such an interaction variable would not have stronger construct
validity than the Herfindahl Index because all of the firms are drawn from the
largest 500 Australian companies, and are large firms for their industry.12
Employee costs Firms are classified as having high exposure to employee
costs (UNO ˆ 1) if the union membership of labour in the firm's primary
industry is greater than 50%; otherwise UNO ˆ 0 (see Moses, 1987). Union
membership is determined from the Australian Bureau of Statistics publication
series Trade Union Members Catalogue No. 6325, and firms are matched with
union membership according to their ASEC. Because unions in different
industries are not equally militant in their approaches, and because firms
usually have employees from several unions other than the main union in their
primary industry, it is inappropriate to use a continuous variable measuring the
rate of union membership in firm's primary industry.13
Executive remuneration The executive remuneration ratio `REMUN' is the
log10 of the total remuneration paid to all executives earning in excess of

10
Companies are classified according to their principal business activity using the
Australian Stock Exchange industry code (ASEC) (Australian Stock Exchange, 1987).
We obtain total sales or assets for industries other than mining from the Australian
Bureau of Statistics Catalogue No. 8221, Manufacturing Industry Australia 1988 ± 1989,
while mining industry sales are obtained from the Australian Bureau of Statistics
Catalogue No. 8402, Census of Mining Establishments: Details of Operations by Industry.
11
We log the Herfindahl Index and other variable measures to normalise the data. When
we transform our measures using natural logarithms instead of logging to the base 10,
we obtain qualitatively identical results. The log10 and logn measures are perfectly
positively correlated, P-Plots indicate that both transformed sets of variables are
approximately normal, and the Smirnov statistics are identical if we use log10 or logn.
Also, we obtain exactly the same model and variable significance and predictive
accuracy using these two alternative logarithmic transformations.
12
Nonetheless, we report an interaction effect in the multivariate tests reported in
Table 3, model 6. As expected, the interaction is insignificant.

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13
When we test for an association between classificatory smoothing and the actual ratio
of union membership in firms' primary industries, we obtain same-sign, but slightly less
significant findings than when we use the dichotomous UNO measure. This is consistent
with the introduction of noise into the continuous variable.

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$85,000, scaled by the 1989 operating profit before extraordinary items

reported in 1990. While $85,000 is an arbitrary figure in some respects, it has
been identified as `high' by regulators who would otherwise not require its
disclosure. The 1990 comparative operating profit is used instead of the 1989
reported figure since managers are expected to smooth from the 1990 measure
to the 1989 measure. Consistent with the hypothesis development and
shareholders' likely concerns about the relative distribution of earnings
between investors and management, REMUN uses operating profit to deflate
management compensation.
Size To provide a comparison with other studies that use firm size as a proxy
for general political cost exposure, we use SIZE, measured as the log10 of total
assets, as a control variable.14
Contracting variables We use an ownership concentration variable (OWN),
which measures the percentage of ordinary shares held by the largest single
shareholder, to determine whether managers of firms whose ownership is not
concentrated in the hands of a single shareholder are more likely to engage in
income smoothing.
Whittred and Zimmer (1986) document considerable variation in debt
agreement specifications for measurement of the interest coverage ratio
numerator. The measures they document generally will be highly correlated.
We therefore measure interest coverage using data that are readily available,
but we acknowledge that the measure is not always applicable to individual
sample firms' debt agreements.15 The interest coverage variable (INTCOV) is
bounded at 0 and 20 and calculated as follows:

Interest Coverage
1989 Operating profit after tax and minority interests
ˆ (1)
1989 Interest Expense

14
To test the robustness of our results to alternative specifications of firm size, we also
fit the reported regressions using log10 of sales instead of log10 of total assets, logn of
sales and logn of total assets. The results do not differ significantly in any tests.
15
Whittred and Zimmer (1986) document variations in relation to such matters as
whether the numerator earnings number uses net profit or operating profit, earnings of
the parent and guarantors only or earnings of the parent and its subsidiaries, profit
before or after interest, and profit before or after tax. Since writing this paper, we have
become aware that Ramsay and Sidhu (1998) find that private debt agreements often
include interest coverage constraints, again with variations in the measurement of the
earnings numerator, and with varying levels of the constraint (between 2 and 4).
Differences in interest coverage measurement are probably compensated for by

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differences in the tightness of the constraint. As such, the measure we adopt should
provide a reasonable approximation for the incentives provided by a range of debt
covenant interest coverage constraints.

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4.2. The smoothing device Ð extraordinary items definition

The income smoothing test in this paper classifies a company as a `smoother'

or a `non-smoother' based on whether the effect of the discretionary
classification of recurring gains and losses is to move its reported net operating
profit after tax and minority interests closer to its expected net operating profit
after tax and minority interests. It is inappropriate to use a continuous measure
of the degree to which smoothing occurred since the degree is constrained by
the incidence and magnitude of the recurring items. That is, to the extent that
there is a finite number of transactions of `questionable classification' that have
specific values, firms are constrained in terms of the extent to which they can
smooth.
To determine 1989 expected earnings we adopt the first order autoregressive
model in the first difference, used by Craig and Walsh (1989). The first order
autoregressive model provides an estimate of change in the current expected
earnings before extraordinary items by generating an average of the change in
past reported net operating profits after tax and minority interests going back t
periods (where t ˆ 8 in this study), together with a random disturbance in the
current period.
Specifically, the expectations model applied to each individual firm's data
and estimated using least squares regression analysis becomes:

Wt ˆ Wt ÿ 1 ‡ ‡ " t (2)

where

Wt ˆ NPBEIt ÿ NPBEIt ÿ 1
NPBEI ˆ Net profit after tax, minority interests, and before extraordinary
items
ˆ Autoregressive parameter
ˆ Drift or trend in the differenced NPBEI series
" ˆ Error

Reported net operating profit time series are prone to heteroscedasticity due
to the effects of different inflation rates and other economic conditions over
time. This prevents the use of a simple linear regression to determine the
earnings trend because the sample variances of the regression coefficients
would be underestimated. Further, it is not possible to use logarithmic or
square root transformation to stabilise the variance because, if a company
reports a loss, the square root transformation of a negative number cannot be
determined. Including the parameter imposes a constant mean and variance

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into the series. The expectations model in equation (2) also assumes that the
process generating yearly differences in individual companies' profits is in
equilibrium over time about a constant mean level. While the autoregressive

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model is relatively crude, discussions with individuals, including politicians and

unionists, indicate that it is likely to reflect the earnings expectations of
politicians and others (such as unionists) for whom the benefits of adjusting
for the income increasing effects of rights issues, etc., are probably insufficient
to justify the information search and processing costs, but who will observe
trends in firms' earnings. When we adopt a random walk model or simple
linear regression to measure expected earnings as in some other studies (e.g.,
Moses, 1987), we obtain qualitatively similar, but statistically weaker results
for all tests, which is consistent with the random walk model being less efficient
in detecting smoothing behaviour.

4.3. The smoothing measure

The existence of income smoothing is tested by using reported earnings data

to generate an expected operating profit figure for 1989. A company is
considered to exhibit smoothing behaviour and is classified as a `smoother' if
classification of recurring profit and loss items as extraordinary in 1989 brings
the 1989 operating profit closer to the expected operating profit than the 1989
operating profit restated in the 1990 comparative accounts. Otherwise, the firm
is classified as a non-smoother unless its 1989 operating profit reported in the
1989 financial statements and the 1989 operating profit reported in the 1990
comparative numbers are equal. In this case, the firm has no recurring items.
Formally, smoothing exists where:

| 89NPEI89i ÿ ENPBEI89i | < | 89NPBEI90i ÿ ENPBEI89i |16 (3)

where

89NPEI89i ˆ Reported net profit after tax, minority interests and before
extraordinary items of company i for 1989 as stated in the 1989
financial statements

16
To demonstrate the smoothing classification, assume a firm earns $12 million
operating profit prior to earnings management in 1989, when it is expected to earn $13.5
million. Now assume that to lift reported operating earnings, the firm classifies a $1
million loss on sale of investments as an extraordinary item, despite the fact that it
frequently trades its investments. In the 1989 accounts, the firm reports $13 million
operating profit which is only $0.5 million less than the expected earnings. In the firm's
1990 comparative restated 1989 accounts, the operating profit would be reported as $12
million and the `real' difference between the expected and reported operating profit
would be $1.5 million (i.e., $13.5 million versus $12 million). Since the expected and
reported operating profit variance in 1989 (difference of $0.5 million which is expected

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operating profit of $13.5 million versus reported operating profit of $13 million) is less
than that reported in the 1990 comparative numbers (the `real' difference of $1.5
million), the firm used classificatory smoothing.

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89NPBEI90i ˆ Reported net profit after tax, minority interests and before
extraordinary items of company i for 1989 as (re)stated in the
1990 financial statements
ENPBEI89i ˆ Expected net profit after tax, minority interests and before
extraordinary items of company i for the year 1989 as
determined by the expectations model in section 3.2.

4.4. Sample and test period

The sample is selected from the ASX Database file of 1,568 firms listed
between 1985 and 1993. Using a computerised word search, only those firms
which disclose `extraordinary items' in their 1989 annual report are retained
(n ˆ 469). From this point, the ASX database cannot be used as it covers only
seven years of data and does not list the restated 1989 financial accounts. Data
for 210 of these firms are available from the AGSM Annual Report File.17
A comparison of the 1989 and 1990 annual reports for these 210 firms
reveals that 98 firms do not restate their 1989 extraordinary item figure in their
1990 accounts. These firms are excluded because their 1989 extraordinary items
consist of entirely non-recurring items and the classification of recurring items
as extraordinary could not have been used to smooth reported earnings.
Another 45 firms are excluded because of missing annual reports for years
between 1980 and 1989. In addition, two firms in the banking industry are
excluded because they are not subject to accounting standards backed by the
Australian Corporations and Securities Legislation, and seven more are
excluded on the basis that they provide insufficient disclosures to measure
independent variables. The final sample consists of 58 companies,18 of which 42
are classified as smoothers, 16 as non-smoothers.
Table 1 outlines the type and number of recurring extraordinary items
restated in the 1990 company annual reports. The most common recurring
extraordinary items are those associated with the sale of investments, disposal
of business segments, sale of property plant and equipment, and diminution of
the value of investments. It is often debatable whether these items are part of
`ordinary' operations. Together, they account for 44% of the restated 1989
extraordinary item transactions.
Income smoothing necessarily involves either increasing or decreasing
reported earnings. The directional effect of smoothing activity on unmanaged
earnings depends upon the relation between unmanaged earnings and expected

17
The AGSM Annual Report File contains over 21,000 annual reports for the top 500

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Australian listed companies and the top 70 New Zealand listed companies by market
capitalisation.
18
The names and industry classifications of these firms are available from the authors
on request.

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Table 1
Main recurring extraordinary items restated in the 1990 accounts from the sample of 58 firms

Main types of recurring items Number of recurring items

Sale of investments 30
Other 19
Change in tax rate 14
Disposal of business 14
Diminution of value of investment 12
Goodwill write-off 12
Sale of property plant and equipment 9
Closure of business costs 9
Asset write off 5
Sale of freehold 5
Other 4
Investment write down 4
Rationalisation costs 3
Non-recovery of advances 2
Legal costs 2
Diminution of value of plant and equipment 2
Sale of land and buildings 2
Loss on put option 2

earnings. This ratio may be clustered above or below one, depending upon the
effect on unmanaged earnings of economic circumstances and events of the year.
For example, company profitability peaked in 1989 (Australian Bureau of
Statistics, 1997a), so firms that smoothed reported operating profits would be
more likely to classify negative recurring items as operating, and positive items as
extraordinary. To establish that the classificatory activity attributed as
smoothing is not really classification to either increase or decrease operating
profits requires comparing the relative frequency of income increasing and
income decreasing effects for each of the smoothing and non-smoothing
samples. The proportions for the smoothing and non-smoothing samples are not
significantly different (Yates Corrected 2 ˆ 1.257, p ˆ 0.262).19 As such, it is
classificatory smoothing that distinguishes the smoothing sample from the non-
smoothing sample, not the direction of the effect of classifications on earnings.

5. Results

Descriptive statistics for the 42 smoothers and 16 non-smoothers are

reported in Table 2, Panel A. In all cases except in relation to industry

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19
27 (15) of the smoothing firms had income decreasing (increasing) classifications of
recurring items, while 7 (9) of the non-smoothing firms had income decreasing
(increasing) classifications. The proportions are not significantly different.

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Table 2
Descriptive statistics and univariate results: Political cost and contracting variables, and their
association with classificatory smoothing

Panel A: Descriptive statistics

Hypothesis= Smoothers Non-Smoothers

Control Expectation Variable (n ˆ 42) (n ˆ 16)

CONC
1. Smoothers > Mean 2.840 2.971
Non-smoothers Std deviation 0.344 0.362
UNO
2. Smoothers > Mean 0.738 0.438
Non-smoothers Std deviation 0.445 0.512
REMUN
3. Smoothers > Mean 0.610 0.110
Non-smoothers Std deviation 3.39 0.200
SIZE
Smoothers > Mean 5.510 5.449
Non-smoothers Std deviation 0.823 0.646
OWN
Smoothers < Mean 0.244 0.394
Non-smoothers Std deviation 0.159 0.230
INTCOV (n ˆ 39) (n ˆ 15)
Smoothers < Mean 0.450 0.366
Non-smoothers Std deviation 0.698 0.651
INTCOVA (n ˆ 29) (n ˆ 14)
Smoothers < Mean 0.226 0.300
Non-smoothers Std deviation 0.630 0.620
INTCOVB (n ˆ 7) (n ˆ 4)
Smoothers < Mean ÿ0.130 0.410
Non-smoothers Median 0.074 0.439
Std deviation 0.350 0.480

Panel B: Univariate tests

Panel B1: Association between political cost and contracting variables and classificatory
smoothing (n ˆ 58)
Student t Mann Whitney U
Test Variable one tailed ( p) one tailed ( p)

CONC 1.280 271.5

(0.103) (0.129)
REMUN 0.58 320.0

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(0.283) (0.390)

(continued)

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Table 2
Continued

Student t Mann Whitney U

Test Variable one tailed ( p) one tailed ( p)

SIZE ÿ0.267 324

(0.396) 0.477
OWN ÿ2.700 208.500
(n ˆ 58) (0.005) (0.013)
INTCOV 0.400 191.000
(n ˆ 58) (0.344) (0.378)
INTCOVA ÿ0.370 264.500
(n ˆ 43) (0.357) (0.292)

Panel B2: Association between union membership and classificatory smoothing

UNO ˆ 0 UNO ˆ 1

Non-Smoother 9 7
Smoother 11 31

Yates Corrected 2
ˆ 3.399, p < 0.050

Panel C: Correlations among independent variable measures

Pearson
correlation SIZE LOGHERF REMUN UNO INTCOV OWN

SIZE 1.000
CONC 0.092 1.000
REMUN 0.213 0.171 1.000
UNO ÿ0.060 0.122 0.085 1.000
INTCOV ÿ0.405 ÿ0.120 ÿ0.012 0.037 1.000
OWN ÿ0.045 0.041 ÿ0.098 ÿ0.072 0.038 1.000

CONC ˆ log10 (sum of squared market share of industry sales for four largest firms in the
relevant industry); UNO ˆ 0 if the degree of union membership is less than 50% and 1 if the
degree of union membership is greater than 50%; SIZE ˆ log10 (Total Assets); REMUN ˆ total
executive remuneration paid to executives whose net remuneration is greater than $85000 divided
by reported 1989 operating profit after tax and minority interests. A company is classified as a
`smoother' if the effect of the discretionary classification of recurring items as operating or
extraordinary reduced the absolute difference between the expected net profit before
extraordinary items and net profit before extraordinary items reported in the 1989 financial
accounts; OWN ˆ percentage of ordinary share capital held by the largest party, IN-
TCOV ˆ log10 | 1989 operating profit after tax and minority interest=1989 interest expense | ,
INTCOVA ˆ log10 | 1989 operating profit after tax and minority interests=1989 interest
expense | including only those companies with issued debt, and INTCOVB ˆ log10 | 1989
operating profit after tax and minority interests=1989 interest expense | including only those
companies with issued debenture deeds.

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concentration (CONC) and interest coverage calculated with the full sample
(INTCOV), the differences in the means and the medians are in the predicted
directions. One-tailed t-tests for differences in group means are summarised in
Panel B of table 2.
Table 2 Panel B1 tests show that industry concentration is not
significantly associated with classificatory smoothing. However, the Yates
Corrected Chi-Square test of Hypothesis 2 reported in Panel B2 indicates
that the degree of union membership is significantly associated with
classificatory smoothing (p < 0.050). The degree of union membership is
also highly significant in the multivariate tests reported in Table 3 (models
2 ± 6). In contrast, the proportion of operating profit paid to top executives
is not significantly associated with smoothing (Table 2 Panel B1 and
Table 3).
The results in Tables 2 and 3 indicate that the ownership concentration
variable, OWN, is the only contracting variable in the predicted direction and
significantly associated with classificatory smoothing (p < 0.050).20 Thus, it
appears that less concentrated equity ownership is associated with more
smoothing. This result contrasts with the insignificant result reported by
Moses (1987), possibly because Moses (1987) measures OWN as a
continuous variable with an upper bound of 20% whereas we measure
OWN as a continuous variable with no upper bound.21 Alternatively, the
thinness of the Australian management labour market might make

20
To assess the effects of debt covenant violation, our univariate tests and the
multivariate regression use both the full sample (n ˆ 58) and only those firms with debt
(n ˆ 43) (INTCOVA). Whittred and Zimmer (1986) examined the cross-sectional
variation in the covenants=rules which are related to the nature of debt. They found that
interest coverage restrictions are an issue only with companies with debenture trust
deeds. However, the sample size is too small to run tests with this sub-sample (n ˆ 12).
21
For more than 60% of this sample, the largest shareholder held more than 20% of the
ordinary capital. 72% of these firms smoothed income whereas 71% of the combined
sample smoothed. Hence, our results are due to differences in policies between firms
with relative ownership proportions either above 20% or below 20%.
To provide evidence of the increased power from not truncating the OWN variable at
an arbitrary upper bound, we recalculate the logistic regression in table 3 first with an
upper bound of 20% and then with an upper bound of 30%. The variable OWN is
insignificant with an upper bound of 20% but significant at p < 0.100 with an upper
bound of 30%. Since the means of both samples approach the arbitrary upper bound of

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20%, it is only when an upper bound of 30% or higher is imposed that the respective
sample means approach their `actual' means. In the non-smoothing sample, most
companies have an ownership control measure exceeding 30%. In contrast, most
measures fall within 0 to 30% in the smoothing sub-sample.

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Australian managers more sensitive to discipline by shareholders who

monitor their performance closely. 22
The correlation matrix in Panel C of Table 2 indicates that the political cost
variables are not highly correlated. This is indirect evidence that each captures
political cost exposure from a different source.
Table 3 reports the multivariate logistic regression models using various
combinations of the political cost and contracting variables. Overall, the
political cost-only multivariate model (Model 2) classifies almost 71% of the
firms correctly. This increases to 74% with inclusion of the contracting
variables (Model 5), although in each case the predictive accuracy is overstated
because there is no independent hold-out sample to test the model's accuracy.
All models, except the base model using only SIZE as a variable, are
significant. Also, all are significant improvements over naive predictions that
half the firms smooth and half do not. The political cost model is not a
significant improvement over a naive prediction that all firms engage in
smoothing. However, it supports a theoretical reason for the distribution being
other than evenly divided.23 The political cost and contracting variable model
is an improvement over any naive prediction.
The results in table 3 provide evidence that the larger the firm's industry
concentration (CONC), the less likely it is that the organisation would engage
in income smoothing (p < 0.050 in models 2 ± 4). This result is opposite to that
predicted. A possible reason is that firms with political cost exposure due to
industry concentration and potential criticism for anti-competitive practices
may attempt to minimise that criticism by choosing always to minimise rather
than smooth operating profit. However, univariate tests indicate that this is not
the case (p < 0.050 for both student t and Mann-Whitney tests, but high
concentration is associated with income increasing classification). Neither

22
Examination of shareholdings indicates only one consistently dominant shareholder,
Australian Mutual Provident Society (AMP). AMP is one of the three largest
shareholders for 19 of the 58 companies. To investigate its role, we code companies
dichotomously according to whether AMP is one of their three largest shareholders in
1989. Refitting the regressions in Table 3 indicates no association between the dominant
shareholder and income smoothing (p > 0.700). However, we find a significant
association at p < 0.050 between the propensity of managers to use income increasing
discretionary classifications of recurring items and the dominant shareholder. Managers
of high profile investment entities such as AMP would likely prefer investees to maximise
earnings so that they, in turn, can distribute high dividends. This reduces the political
costs associated with low or moderate earnings. As opposed to manufacturing, retail,
travel and service industries, AMP faced little government regulation of a highly political

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cost nature at the time. The political costs associated with pricing, environmental damage
etc. facing AMP tend to be lower than for firms in other industries.
23
As Watts and Zimmerman (1986) comment, being able to use theory to predict the
most popular outcome is important in itself.

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Table 3
Logit analysis of political cost and contracting variable associations with classificatory smoothing
Dependent variable: Smoother
(Smoother ˆ 1 Ð if the discretionary classification of recurring items as extraordinary reduced the
absolute difference between expected net profit before extraordinary items and net profit before
extraordinary items reported in 1989 financial accounts. Otherwise, `smoother' ˆ 0)

Model 1 Model 2 Model 3 Model 4 Model 5 Model 6

Variable (S.E.) (S.E.) (S.E.) (S.E.) (S.E.) (S.E.)

(Predicted sign) p (1-tail) p (1-tail) p (1-tail) p (1-tail) p (1-tail) p (1-tail)

Constant 0.365 4.901 4.168 7.932 7.249 2.298

(2.139) (2.830) (3.625) (3.793) (4.705) (3.504)
0.432 0.042 0.125 0.017 0.061 0.256
CONC ÿ1.674 ÿ1.782 ÿ2.314 ÿ2.316
(‡) (0.989) (1.001) (1.262) (1.263)
0.046 0.038 0.033 0.067
UNO 1.503 1.486 1.908 1.906 1.296
(‡) (0.665) (0.669) (0.811) (0.808) (0.716)
0.012 0.013 0.009 0.009 0.035
REMUN 0.177 0.166 0.120 0.114 ÿ0.033
(‡) (0.478) (0.460) (0.358) (0.361) (0.404)
0.356 0.359 0.369 0.376 0.468
SIZE 0.105 0.188 0.123 ÿ0.221
(‡) (0.388) (0.442) (0.504) (0.626)
0.393 0.386 0.403 0.362
OWN ÿ4.784 ÿ4.789 ÿ3.920
(ÿ) (2.044) (2.047) (1.815)
0.010 0.010 0.016
INTCOV 0.1657 0.200 0.331
(ÿ) (0.551) (0.566) (0.541)
0.382 0.362 0.270
CONCHERF 0.002
(0.003)
0.219
2
0.074 7.946 8.179 15.791 15.851 12.920
Significance 0.786 0.047 0.085 0.008 0.015 0.044
ÿ2 Log Likelihood 67.598 60.379 59.493 48.020 47.960 50.891
Goodness of Fit 56.963 56.053 55.418 42.090 42.751 48.288
% Correctly classified 71.93 70.69 70.18 72.22 74.07 75.93

CONC ˆ log10 (sum of squared market share of industry sales for four largest firms in the
relevant industry)
UNO ˆ 0 if the degree of union membership is less than 50% and 1 if the degree of union
membership is greater than 50%
REMUN ˆ total executive remuneration paid to executives whose net remuneration is greater
than $85000 divided by reported 1989 operating profit after tax and minority interests.
SIZE ˆ log10 (Total Assets);
OWN ˆ percentage of ordinary share capital held by the largest party

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INTCOV ˆ log10 (1989 operating profit after tax and minority interest=1989 interest expense)
CONCHERF ˆ Firm's own share of industry sales X its Herfindahl Index.

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traditional short-term political cost arguments nor our longer-term arguments

can explain this association.
The results indicate that firms with a high degree of union membership are
more likely to smooth income than firms with low degrees of union
membership (p < 0.050 in all models 2 ± 6). In contrast, Moses (1987) finds
no such effect. Possible reasons for this difference include the temporal and
institutional settings of the studies (US 1975 ± 1980 versus Australia 1989 ±
1990) and the fact that Moses (1987) uses a smoothing measure based on single
period earnings forecasts whereas this study uses a multi-period forecasting
model. Firm size and degree of unionisation of the firm's workforce are
positively correlated (OECD, 1992, p. 61). Hence, a partial explanation for the
Craig and Walsh (1989) finding of an association between income smoothing
and firm size could be the effect of union presence.
The results do not support the hypothesis that the larger the ratio of executive
remuneration to operating profits, the more managers engage in income smoothing
behaviour. In contrast, Hoffman and Zimmer (1994) find moderate support for
their prediction that managers who are remunerated highly, relative to the
magnitude of the earnings of the firm, classify gains as operating and losses as
extraordinary. To investigate the issue further, we classify the main recurring
extraordinary items restated in firms' 1990 accounts according to whether the items
are income increasing or decreasing, and whether the firms, on balance, used
classifications to increase or decrease their operating profits.24 The results indicate
that 66 (44%) of discretionary classifications of recurring gains and losses are for
income increasing firms and 84 (56%) are for income decreasing firms. Of the 58
sample firms, 24 have net income increasing recurring extraordinary items and 34
companies have net income decreasing extraordinary items. Tests of the association
between income increasing=decreasing discretionary techniques and management
remuneration indicate that there is only weak support for the Hoffman and
Zimmer finding that managers who are remunerated highly are more likely to
classify gains as operating and losses as extraordinary (t ˆ 1.270; p ˆ
0.105).25

6. Conclusion

Our results are consistent with the prediction that companies subject to
wealth transfers because of their exposure to labour-related political costs

24
Details are available from the authors upon request.

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25
This test is also run with management remuneration measured first as the directors'
fees reported in 1989 divided by 1989 restated operating profit and second as the sum of
reported directors fees and management remuneration greater than $85, 000 reported in
1989. The results indicate that there is again only marginal support that managers who
are remunerated highly are more likely to classify gains as operating and losses as
extraordinary. (t ˆ 1.45; p ˆ 0.077 and t ˆ 1.310; p ˆ 0.097)

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attempted to affect the probability of such transfers via their classification of

recurring gains and losses as extraordinary or operating. It is possible that one
reason why Liberty and Zimmerman (1986) found no evidence that managers
reduce reported earnings during labour union contract negotiations is because
managers adopted a long-term approach to labour negotiations. Possibly,
managers foresaw the potential for labour contract negotiations and smoothed
earnings peaks to reduce apparent labour exploitation or ability to pay, and
smoothed troughs to maintain employee morale.
We find that firms with low ownership concentration appear more likely to
engage in income smoothing behaviour than firms with high ownership
concentration, but interest coverage levels do not affect managers' propensity
to do so. We also provide weak support for the Hoffman and Zimmer (1994)
finding that managers used classification techniques to boost rather than
smooth reported earnings, thereby minimising the apparent management share
of firm earnings, relative to the investors' share.
The conclusions of this study are tempered by several limitations. The first is
that the results have limited generalisability. We classify companies using one
variable: classification of recurring losses and gains. However, managers have a
variety of discretionary techniques available to smooth reported income and
may apply individual techniques or a portfolio of techniques to achieve their
smoothing goals, perhaps with some choices offsetting in nature. Since this
study relies on publicly disclosed information, firms that manipulate reported
net profit are potentially excluded from the sample to the extent that their
manipulation is not discernible. There is no reason to suspect that `hidden
smoothing' is systematically negatively associated with the smoothing
behaviour observed in this study, so it is unlikely that the results reported in
this study are overstated. To the extent that `hidden smoothing' is positively
correlated with the observed classificatory smoothing, they are, in fact,
understated. Another limitation is that we construct the market share and
union membership variables using the firm's principal business activity. In the
case of diversified companies, this may understate firms' exposure to political
costs and proxy for an omitted variable Ð possibly one related to the firm's
investment opportunity set (Skinner, 1993).
Future research could centre on the development of a more comprehensive
multi-variable smoothing model that incorporates the various discretionary
income smoothing techniques that are available to management. Such research
would be useful in developing or refining models of managerial choice.

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