Scribd Logo
Upload

Welcome to Scribd!

  • PDF

    Uploaded by

    Maen
    10 views13 pages

    Original Title

    1111111.pdf

    Copyright

    © © All Rights Reserved

    Available Formats

    PDF or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    Report this Document

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    Download as pdf
    10 views13 pages

    PDF

    Uploaded by

    Maen

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    Download as pdf
    of 13
    Classificatory Smoothing of Income with Extraordinary Items Amir Barnea, Joshua Ronen and Simcha Sadan extraordinary revenues and expenses are used to smooth ordinary or operating income over time. While the subject of income smoothing was discussed and tested previously [Gordon, 1964; Gordon, Horwitz and Meyers, 1966; Archibald, 1967; Copeland, 1968; Cope- land and Licastro, 1968; White, 197 Cushing, 1969; Dasher and Malcom, 1970; Barefield and Comiskey, 1972; Beidleman, 1973], the role of extraordinary items never was tested for specifically and sepa- rately.! This observation is most striking, particularly in view of the fact that by applying different smoothing mechanisms, extraordinary items can be used to smooth various series, such as net, ordinary or operating income. Although past studies assumed that smoothing is practiced in order to affect the income stream presumably utilized by financial statements users, the focus was exclusively on the net income numbers (after extraordinary items), when, in fact, ordinary income (before extraordinary items) per share is the focal number of users of financial statements? and, there- fore, should be the object of smoothing. Indeed, income smoothing could be de- signed to convey information relevant for the prediction of future earnings. If we assume management has some knowledge about the firm’s future earnings, the T= paper presents tests of whether 110 smoothing of ordinary income with ex traordinary items could be undertaken to produce an income number that can be used to predict future earnings efficiently. In this case, smoothing is used as a vehicle for management to convey its expectations within the framework of conventional ac- counting practices which do not permit direct forecasts. In fact, this contention is consistent with the finding that ordinary income is superior to net income as a pre- dictor of future earnings [Ronen and Sadan, 1974]. It is also consistent with the Helpful comments of Dr. M. Schiff and the assistance of Mr. J. Pretter and Tavy Ronen are acknowledged. 2 Beidleman [1973] reports the lack of sufficient data 1s a reason for the omission, In Dasher and Malcom’s study, extraordinary items were one of four smoothing variables, the effects of which were jointly tested. Thus, the separate impact of extraordinary items on the varia tions in income could not be ascertained, * Contacts with Wall Street analysts confirmed this. ‘Also, the price earnings ratios communicated by The Wall Street Journal, for example, are computed on the basis of ordinary income (hefore extraordinary items). Indeed, underlying APB opinions No. 9 [ATCPA, 1966] and No. 30 [AICPA, 1974] which supersede No. 9 about the segregation of extraordinary items from ordinary income have probably the objective of improving the predictability of future earnings or cash flows through the provision of information that allows users to focus attention on ordinary income. Amir Barnea is a Senior Lecturer at Tet Aviv University, Israel; Joshua Ronen is Associate Professor and Simcha Sadan is Assistant Professor at New York University Schools of Business and The Vincent C. Ross Institute of Accounting Research. Barnea, Ronen and Sadan: Classificatory Smoothing aut indirect evidence provided by Gonedes [1974] and Beaver [1974] regarding the informational content of special account- ing items. ‘Tue Dimensions AND OpjEcts OF SMOOTHING Income smoothing is the deliberate dampening of fluctuations about some level of earnings considered to be normal for the firm. It can be accomplished along several smoothing dimensions: 1. Smoothing through events’ occurrence and/or recognition: Management can time actual transactions so that their effects on reported income would tend to dampen its variations over time. Mostly, the planned timing of events’ occurrences (e.g., re- search and development) would be a func- tion of the accounting rules governing the accounting recognition of the events. 2. Smoothing through allocation over time: Given the occurrence and the recognition of an event, management has some dis- cretionary control over the determination over the periods to be affected by the event’s quantification. 3. Smoothing through classification (hence, dlassificatory smoothing): When income statement statistics other than net income (net of all revenues and expenses) are the object of smoothing, management can classify intra-income statement items to reduce variations over time in that sta- tistic. In this paper we focus on the degree to which revenue and cost items which can be classified as ordinary or extraordinary are used either alone or incrementally for smoothing income statistics other than net income.* CLASSIFICATORY SMOOTHING WITH Extraorprnary Irems Nonirecurring items could, within bounds, be classified as ordinary or extraordinary. Thus, if management wishes to impart a smoother appearance to the reported stream of “ordinary income before extraor- dinary items,” it can use whatever discre- tion it has in the classification of nonrecur- ring items to achieve its objective. This is particularly true prior to Opinion 30 [AICPA, 1973] because Opinion 9 [AICPA, 1966] did leave management more flexibility in classifying nonrecurring items as either ordinary or extraordinary [Barnea, Ronen and Sadan, 1975]. ‘This flexibility generally is manifested in borderline cases. These cases include the sale of a plant or a significant segment of the business; the sale of an investment not acquired for resale; and the writeoff of goodwill due to unusual events. In addi- tion there are borderline items for which, if material, a separate disclosure is recom- mended, which could be interpreted by investors as extraordinary. Examples of such items are material writedowns of in- ventories, receivables or deferred R & D expenditures; provision for loss on major long-term contracts; or purchase commit- ments or losses on dispositions of assets or business segments. The use of such flexibil- ity is illustrated by Shank and Burnell [1974, p. 136] who report on a major con- glomerate that showed an extraordinary gain of $3.2 million in the second quarter of 1972. The gain resulted from settlement of an outstanding law suit, and the com- pany also announced that it was setting up a reserve of $3.2 million to provide for 8 This is similar to the definition proposed by Beidle- man [1973]. We omitted from his definition (which is: the intentional dampening of fluctuations about some level of earnings that is currently considered to be nor- mal for a firm) the underlined word (“intentional” since this implies knowledge of management intentions and perceptions that are not operationally testable through study of nonbehavioral empirical data, such as neither hisor ours. This aspect wil be elaborated below. * We are not concerned here with the characterization of a given set of firms as smoothers or nonsmoothers in seneral, as was the explicit or implicit objective of past studies’ For Copeland, for example, this was an explicit objective, which explains his preference for testing many Yatlables at a time mafatis mutandis rather than one variable at a time, Copyright © 2001 All Rights Reserved phe) losses from the anticipated elimination of a product line. Classifying the reserve as extraordinary loss could be designed to prevent future losses related to the said product line from disturbing an otherwise favorable ordinary income trend. Indeed, these possible uses of the flexibility prob- ably gave rise to Opinion 30 as evidenced perhaps by the generally negative light with which the APB viewed management’s discretion regarding classification. ‘TESTING FoR CLAssIFICATORY SMOOTHING wiTH EXTRAORDINARY ITEMS A test for classificatory smoothing with extraordinary items should be designed to observe whether items which potentially could be classified as extraordinary or ordi- nary were used to smooth ordinary income (before extraordinary items) rather than net income (after extraordinary items).* ‘This necessitates assumptions with respect to (1) management's expectations regard- ing the magnitude of future earnings; (2) what is perceived by management as a de- sirable time distribution of ordinary in- come from the standpoint of analysts’ and investors’ perception of the company’s growth; (3) management’s anticipation as to the future magnitude of discretionary variables with smoothing potential; and (4) management’s potential ability to manipulate either the timing, the magni- tude or the accounting classification of the variables for smoothing purposes. The specifications of these assumptions are necessarily subjective and researcher- specific. The test results are contingent on the set of assumptions employed and, even for given data, test results derived from different sets of assumptions may differ or even conflict. This must be borne in mind before the conclusions of any smoothing study can be generalized. Moreover, tests that use financial state- ments data rarely can substantiate a mo- tivational link. Tests utilizing time series ‘The Accounting Review, January 1976 of income numbers and smoothing vari- ables hardly can produce evidence that substantiates a particular hypothesis about the motivation for smoothing. The latter would require a more highly controlled ex- perimental environment in which firms’ managers play a significant role. Thus, a smoothing study utilizing annual earnings that supports the smoothing hypothesis does not necessarily establish that man- agement attempted to smooth income, but only that it behaved as if it attempted to smooth income. The results would not enable us to draw conclusions as to the motivation for their apparent underlying mechanisms. The Specific Method of the Study We studied two operational definitions of the objects of smoothing—the variables whose variation over time were to be dampened (hence, smoothed variables): (1) ordinary income before extraordinary items per share and (2) operating income before period charges and extraordinary items per share. The choice of the first smoothed variable was made because the investing public pays attention to per share ordinary in- come before extraordinary items in analyz- ing trends and predicting future earnings. The choice of the second smoothed vari- ables (operating income before period charges and extraordinary items) was mo- * For example, the board justifies the all-inclusive net income concept because, among other things, “. .. they also stress the dangers of posse manipulation of an- nual earnings’ figures if such items may be omitted from the determination of net income,” and“... When judgment is allowed to determine whether io include or exchide particular items or adjustments, significant differences develop in the treatment of borderline cases, and that there isa danger that th us of ‘extraordinary? as a criteria may be a means of income” @aragraph 14 of Opinion 9). Ancodotal evidence re- garding the presumed manipulatory exploitation of this tion is reported by Frederick Andrews [1972]. "Such a test differs from tests for nonclassificatory smoothing dimensions, The latter are tests of smoothing variables with respect to thelr smoothing impact on the net income afer their respective magnitudes of revenue and expense were recorded. Barnea, Ronen and Sadan: Classificatory Smoothing 113 tivated by the possibility that manage- ments believe that analysts and the invest- ing public pay primary attention to operat- ing income as a measure of managerial performance—a variable which is not af- fected by period charges which are assumed not to correlate with operating income and which could possess manipulative potential. To determine the “normal” income numbers from which deviations presum- ably were intended by management to be smoothed away, we used two methods: 1. Time trend: We detrended (via time re- gression) the series of smoothed vari- ables for a span of 20 years, 1951 to 1970. (For a discussion of the procedure see “The Test Design” below.) We based this on the assumption that management deems as desirable a time trend of earning per share. Such an assumption frequently recurs in the general business literature.” The trend resulting from the regres- sion is an ex-post measure implying foreknowledge of both the magnitude of earnings and their 20-year distribu- tion. While this implication might ap- pear restrictive at first, it should fare well under a careful scrutiny: First, management—f it attempts to smooth the income’s time trend—must, as a precondition, forecast its future earn- ings as reliably as it can, in order to de- velop a smoothing strategy (i.e., de- velop a target annual number to be re- ported that directs the smoothing pro- cess). Ad hoc attempts to adjust cur- rent income to minimize its difference from the preceding year’s income sim- ply may fail to produce long-run smoothing and, indeed, may produce countersmoothing in the long run. Sec- ond, management is in the best position to forecast its earnings since it alone knows of plans.and decisions that affect earnings. Third, the actual ex-post trend of earnings is uniquely identifiable whereas, if foreknowledge or relatively accurate forecasts of future earnings are ruled out, an infinite number of ex- pectation models potentially could be assumed. We think that the choice of the ex-post earnings trend is both less arbitrary and more sensible. 2. Leader trend: We regressed the series of the firm’s smoothed variable on the series of the observed magnitude of the smoothed variable of the leader in the industry in which the firm is classified. The “normal” income numbers were assumed to lie on the resulting regres- sion line. Thus, it is assumed that each year the firm’s management obtains in- formation on the leader's earnings prior to its own determination of the value of the smoothed variable. For our purposes, the industry’s leader was identified as the company with the largest market share in reve- nue. (The names of the leaders as well as a list of the companies used in the test sample appear in Appendix I. Further discussion about the choice of the sample firms occurs below.) The choice of the leader is based on the con- tention that investors and security analysts are interested primarily in a company’s performance relative to in- dustry changes. It is an empirical fact that research departments of securities investment houses (eg., brokerage houses) are decentralized according to the standard industry classification (SIC). Industry analysts usually mea- sure the individual firm’s performance. 7 Some evidence on this is given in The Wall Strect Journab article referred to earlier and in Shank and Burnell [1974]. Note that this assumption does not im- iy that a linear time trend fits observed income num- ets better or as well as other time-series models (such as those tested by Gonedes {forthcoming] and Ball and Watts [1972]. A criterion of such fitness, however, is neither necessary nor important for the purpose of our tests. What is important is to reasonably approximate ‘what management viewsasa desirable trend. Copyright © 2001 All Rights Reserved 114 We used the leader’s measures of per- formance (smoothed variable) as a sur- rogate for the industry’s average’ to test whether firms attempted to mini- mize deviations from the leader’s trend. The Operational Definition of Earnings Ordinary income before extraordinary items was derived from the Compustat tapes (version 1951-1970) by adding back to net income after tax (but before net-of- taxes-extraordinary-items) the nonoperat- ing and nonrecurring expenses adjusted for tax.? The net income before fixed charges was taken directly from the Compustat tape (item 13 on the industrial tape). (De- tailed definitions appear in Appendix II.) Extraordinary Items—The SmoothingV ariable For the purpose of this study, extraordi- nary items were defined to include both (1) those reflected in the annual state- ments before taxes and before the compu- tation of net income before taxes and (2) those reflected net of taxes, below net in- come before extraordinary items. To de- termine whether management used ex- traordinary items for smoothing purposes, it was assumed that, in the absence of de- liberate smoothing by management, the incidence of the extraordinary items would have been such that every year a constant amount would have been reported an- nually in the income statement as an ex- traordinary item. We assumed a constant stream of extraordinary items since there is no a priori reason to believe that they increase like other variables (such as pen- sion expenses, incentive compensations, etc.).!° Thus, the annual deviations of ex- traordinary items were determined relative to some constant.!! We used a nonzero constant as the basis for computing the deviations because, by accounting conven- tions, some transactions must be con- sidered extraordinary. Thus, even if ex- traordinary items are defined as nonrecur- The Accounting Review, January 1976 rent, management as well as investors may well expect some extraordinary items to recur on the average and in the aggregate (combinations of transactions) even though not in specific. We used the actual mean of the extraordinary items (determined ex- port over 20 years) as the constant relative to which the deviations were computed on the basis of the assumption that the ex- traordinary items were uniformly available for classificatory smoothing over the 20 years.!? In fact, the tests are not too sensi- tive to this assumption and different con- stants do not change the results signifi- cantly. The Test Design The test procedure applied consisted of the following: 1. We detrended the smoothed variables for the years 1951 to 1970 by regression "The leader was selected in liew of the industry aver- age since by all probability the leader’s annual income ‘number would be known prior to those of all the firms in the industry as would be requited to compute the average, ° The adjustments were made on the basis of an aver- age tax rate (see Appendix ID). A pilot smoothing text of limited sample of firms did not indicate significant dif- ferences in the tests? results when a 25 percent average tax rate (capital gains’ rate) was used in lieu of the average tax rate. W In his study, Beidleman [1973] detrended his six income-smoothing variables as well as net earnings through time regression. However, for our sample of firms, the slope of the extraordinary items? time-trend line ranged between 0,001 and 0.09, with 75 percent of the firms having a slope of less'than 0.04. That is, the time growth of extraordinary items is not significantly different from zero. ¥ See also the discussion of this particular aspect in the section below entitled “Results and Discussion.” ® This assumption would be justified either if the ex- traordinary items were uniformly distributed over the 20 years (and, thus, noncorrelated with ordinary items that cannot be potentially labeled extraordinary) o if the company unrestrictedly could switch “potentially labeled extraordinary” items across years for classifica- tory smoothing purposes (investment writeotfs could be an example). ¥ Tt should be noted that smoothing tests must be based on the observation of the relevant variables over a long time span. Tests limited to a short span might reveal behavior consistent not only with smoothing (ex-post dampening of income variations), but also wit nonsmoothing behavior, such as maximizing, or merely the random occurrence of the discretionary variables and their accounting communication, For a detailed discussion of this point see Copeland [1966]. Barnea, Ronen and Sadan: Classificatory Smoothing 115 both on time and on the leader’s smoothed variables, as per Equation (1): E,=a;+ BV + Up; f= 1,2 1 t= 1951, +++, 1970 2 where = observed smoothed variable in year ¢ Vurt Vu=leader’s observed smoothed vari- able in year f. 2. We determined the deviations (U;) of the smoothed variables from their trend. We also computed the deviations of the actually reported extraordinary items from their constant trend as reflected below: dy = er — 1/20,2e @ where e,= observed extraordinary expense (income) per share in year /. 3. The extraordinary item deviations, ds, were regressed on the smoothed variables’ deviations (U,,) as follows: d= at Wp + Wy @) Thus, smoothing is indicatzd if (1) above trend smoothed variable (Uj:>0) is asso- ciated with above trend extraordinary revenue or below trend extraordinary ex- pense (d; <0), or (2) below trend smoothed variable (U/j:<0) is associated with below trend extraordinary revenue or above trend extraordinary expense (d,>0). Un- der these situations, if the extraordinary revenues and expenses (or parts thereof) were recorded as ordinary revenues and expenses, respectively, the time variations in the magnitudes of the smoothed vari- ables will have been observed to be larger in absolute value and identical in sign. In particular, net ordinary income before ex- traordinary items will have been observed to fluctuate more if these associations had been absent. As recalled, the d,’s were determined with respect to the constant trend of ex- traordinary items which was assumed to be one-twenticth of the total observed magnitude of extraordinary items over the 20 years. However, this total magnitude could be less than the total 20-year pool of items that potentially could be labeled as extraordinary since the observed extraor- dinary items do not include items that were classified as ordinary. As a result, it could be argued that, under our assump- tions, the normal mean of extraordinary items that we used in determining the deviations (d,) should have been increased by some constant 6 reflecting the items classified as ordinary. Nonetheless, the probability that such an addition of 6 to the normal mean will alter our conclusions regarding the existence of classificatory smoothing can be shown to be relatively small. Sample Data ‘The sample data included firms from four industries: (1) paper, (2) chemicals, (3) rubber and (4) airlines (see Appendix 1). The leading firms in the industries used in the determination of the normal trends (the leader’s income stream) were Interna- tional Paper; Du Pont; Goodyear; and United Airlines, respectively. These indus- tries were chosen because of the relative homogeneity of their products. They did not include highly conglomerate or diversi- fied companies, and their results were, therefore, viewed to be more representa- tive of their line of business than in the case of more diversified industries. Results and Discussion The study results are summarized in Tables 1 through 5. Table 1 gives the overall sample results for both ordinary income and operating income as the smoothed variable, with time trend and leader’s trend as the determinants of nor- mal income. The four industries’ results for the two smoothed variables and two Copyright © 2001 All Rights Reserved 116 ‘The Accounting Review, January 1976 Oza aso 8 92 1 Ficurr 1 Frequency Distrisuvion or 62 Furs my THe Sawpre By INTERVALS OF 7 (COEFFICIENT OF CORRELATION BETWEEN THE DEVIATIONS) 1 THE CasE oF Time TREND oF Net Onpivary Income normal income assumptions are included in Appendix III, Tables 2 through 5. Fig- ure 1 shows the frequency distribution of the correlation coefficients between devia- tions of ordinary income and extraordinary items from their respective assumed levels, and Figure 2 shows the distribution of the correlation coefficients between devi=tions of operating income and extraordinary items. Of major interest is the relation between the deviations of the smoothed variables and those of extraordinary items. We pre- sent, in Tables 1 through 5, the correlation coefficients between the two deviation series. Negative correlation coefficients in- a dicate that overtrend smoothed variables are associated with overtrend extraordi- nary revenues or undertrend extraordinary expenses; or that undertrend smoothed variables were associated with undertrend extraordinary revenues or overtrend ex- traordinary expenses. That is, negative correlation coefficients would indicate clas- sificatory smoothing behavior. (See also later discussion in this section.) ‘We utilize the standard error of the re- gression coefficient to test the significance of the association between deviations. The summary of the correlation coefficients in- formation shown in each table has been grouped by the level of significance for rt + T 6 7 8 +—+-—+ Oo 2 3 9 1.0 Frourr 2 Frequency Disrrrmution or 62 Freats 1N THe SAMPLE By INTERVALS OF ¢ (COEFFICIENT OF CORRELATION BETWEEN THE DEVIATIONS) tN THE Case or Time TREND OF Net Oprratinc Income Barnea, Ronen and Sadan: Classificatory Smoothing 117 Tate 1 Sosnuany oF CoRRELATION COEFFICIENTS AND REGRESSION COEFFICIENTS FOR THE 62-Frmat SAM. Level of Significance of Regression Coefficient &* ——| pValue r0 Sign Smoothed | “Normal” |———______ Test Variable | Income 054 | S41 | Total 05. A | Total} one Ordinary | Time trend 5 13 | 38 1 1 2 4 | 0.0000 income | Leader trend a to | 52 | — | 2 4 6 | 20000 Operating | Time trend 7 | a 45 1 1 15 17 0002 ‘income | Leader trend 6 uw | 37 | 3 1 a7 | at | 2020 + Based on Student-t Tests for small samples. tr=Correlation coefficient between the deviations of the smoothing variable and deviations of the smoothed variable, their respective regression coefficients, based on the Student ¢ Test for small samples. This is equivalent to a test on the correlation coefficients which, like the re- gression coefficients, are measures of the presence or absence of a relationship be- tween the variables regressed. Examination of the results strongly indi- cates a support for the smoothing hy- pothesis; ie., the hypothesis that manage- ments behave as if they smoothed income before extraordinary items (both before and after fixed charges) through the ac- counting manipulation of extraordinary items." Similar results are observed under both the time-regression and the leader re- gression. These results further imply that our assumption of a constant trend of extraordinary items computed as one- twentieth of the total extraordinary items does not introduce a bias, since an actual positive growth over time of extraordinary items, coupled with an assumption of a constant stream, would have biased the resulting absolute correlations coefficients between the measured deviations down- ward. Thus, the observation of significant negative correlation coefficients—in spite of the assumption of a constant stream when, in fact, a positive growth occurs— indicates a strong confirmation of “as if” smoothing behavior. ‘The results are stronger in the case of ordinary income than in the case of operat- ing income, as reflected in comparisons be- tween the appropriate rows of Table 1. In the case of ordinary income, 58 of the total sample of 62 firms (94 percent) are asso- ciated with a negative r, with 40 firms among these (65 percent) significant at the 0.05 level when the time regression model is used. Similarly, when the leader regres- sion model is used, 90 percent of the firms exhibit negative r, 61 percent of these sig- nificant at the 0.05 level. In the case of operating income, only 74 percent of the firms have a negative r (44 percent of these significant at the 0.05 level) using the time regression model and 64 percent with negative r (30 percent of these significant) using the leader regression model. None- theless, in the case of operating income as well, the results support the smoothing hypothesis. Examination of the individual indus- tries’ results (Tables 2-5 in Appendix III) shows small differences in the pattern of results of the separate industries. In the case of ordinary income, the percentage of firms with negative r ranges between 0.91 and 1.00 when time regression is used. The fact that the range is larger when the leader regression is used (0.70-1.00) is ¥ The meaning and implication of “as if” smoothing was Clarified earlier, Copyright © 2001 All Rights Reserved 118 caused by the lower percentage of the rubber industry (70 percent) which could, in turn, be explained by the switching of two firms from negative r in the time re- gression to a positive r in the leader regres- sion. In the case of operating income, less than one-half of the firms in the Air Trans- port Industry indicate smoothing behavior (46 percent in the time regression and 34 percent in the leader regression). This con- trasts with 93 percent (time regression) and 92 percent (leader regression) in the case of ordinary income. One could con- jecture that the relatively higher propor- tion of period charges in the airline indus- try, as compared to other industries, ex- plains this result. The other three indus- tries indicate smoothing behavior, al- though not as strongly as in the case of ordinary income and with more variation among the industries (the percentage of firms with negative r ranges between 0.72- 0.82 when time regression is used and be- tween 0.60-0.80 when the leader regression is used). Our results confirm the classificatory smoothing hypothesis with respect to ex- traordinary items. This highlights the im- portance of the testing methodology and of the conceptual foundation for the tested hypothesis. Had we examined the effects of observed extraordinary items on net in- come (after extraordinary items), a counter- smoothing behavior would have been indi- cated. That is, overtrend net income (after extraordinary items) would have been ob- served asassociated with overtrend extraor- dinary revenues or undertrend extraordi- nary expenses; or that undertrend net income (after extraordinary variables) would have been observed as associated with un- dertrend extraordinary revenues or over- trend extraordinary expenses. If manage- ment had engaged in nonclassificatory smoothing through either event recognition or time allocation, opposite results should The Accounting Review, January 1976 have been observed. Accordingly, observa- tion of the above results would have led to an inference of counter event-or-time-allo- cation smoothing. Indeed, because of this, we may conclude that had there been any smoothing of the event-recognition or the time-allocation variety in our sample firms, it was dominated by classificatory smoothing. Clearly, the failure to dis- tinguish between classificatory and non- classificatory smoothing could have led to the wrong conclusion. It could be argued that the results might be attributed to the co-movement of extraordinary items with factors determin- ing income, such as sales. It could be con- tended that overtrend income is associated with overtrend extraordinary revenues or with undertrend extraordinary expenses because the market conditions are favor- able, in general, and they would cause an increase in both the factors underlying ordinary income and those underlying ex- traordinary revenue. However, by their very nature, extraordinary items are indi- vidually nonrecurring, and they are not affected as much by general market condi- tions as are the factors underlying ordi- nary income (sales, cost of sales, etc.). Concrusions Smoothing behavior was indicated when the relation between deviations of two versions of income before extraordinary variables from their time and industry Jeader’s trend and deviations of extraordi- nary items from a constant trend was examined. We distinguish in this paper be- tween two major kinds of smoothing: (1) classificatory smoothing refers to the smoothing over time of intermediate in- come numbers (i.e., not net of all revenues and expenses) through reclassification of ® Indeed, we conjecture that had Beidleman included ¢xtraordinary items among his smoothing variables, his hypothesis formulation and his experimental design ould have Jed him to observe countersmoothing be- ior. Barnea, Ronen and Sadan: Chassificatory Smoothing certain items; (2) nonclassificatory smooth- ing refers to the smoothing over time of net income (net of all revenues and ex- penses) through the manipulation of the occurrence of events, their accounting recognition and/or their allocation over time. Prior research focused on tests of nonclassificatory smoothing. We tested whether extraordinary items were used in classificatory smoothing. Our results are, indeed, consistent with the hypothesis that managements behaved as if they classified items which potentially could be labeled as extraordinary so as to dampen the fluctuations over time of income before extraordinary items.!® This is the first in a series of studies de- signed to test empirically financial state- ments’ format variables that include the time sequencing of different financial statements’ items, their order of presenta- tion, level of aggregation, etc. In this study we concentrated on the possibility that items other than the final net income figure would be subject to manipulatory time sequencing. Future research should be de- signed to extend this test to variables other than extraordinary items. The choice of models and items to be tested should be motivated by knowledge (or beliefs) of how investors (and their advisers) use financial statements for their prediction purposes. 119 2800—Chemicals Air Products (Chemicals) 6700 ‘Air Reduction 6900 ‘Allied Chemicals 13000 American Cyanamid 21900 ‘Atlas Chemicals Industries 53841 Celanese Corp. 131500 Chemetron Corp. 144744 Commercial Solvents Corp. 171700 Dart Industries 203040 ‘Diamond Shamrock 215701 ‘Dow Chemicals 225000 Du Pont 229300 Filtrol Corp. Del. 265300 FMC Corp. 281740 Grace (WR) & Co. 319900 Hecules Inc. 351700 Inmont Corp. 378879 Koppers Co. 413600 Mac Andrews & Forbes 443000 Minnesota Mining & Mfg. 482800 ‘Monsanto Corp. 491010 PPG Industries 556796 Pennwalt Corp. 374305 Reichhold Chemicals 613950 Rohm/Flaas 627900 Stauffer Chemicals 691900 Union Carbide Corp. 634100 3000—Rubber Armstrong Rubber 47430 and Tire Cooper Tire Rubber 188700 Dayco Corp. 205080 Dunlop Co. Ltd. 228652 Firestone Tire & Rubber 266300 Goodrich (B.F.) 317900 Goodyear 318100 Mansfield Tire Rubber 449700 ‘Mohawk Rubber Co. 487100 Rubbermaid, Inc. 632650 Uniroyal, Inc. 738651 4511—Air American Airlines 47300 ‘Transport, Braniff Airways 87900 Continental Airlines 185000 Delta Airlines 209700 Eastern Airlines 234000 ‘Emery Air Freight 245200 National Airlines 504500 Northwest Airlines 541210 Pan American Airlines 364100 Seaboard World Airlines 647600 TWA 726640 United Airlines 732795 ‘Western Airlines 781000 * The leader in each industry is underlined. AppENDIx I THe SAMPLE Com- pustat Tdenti- fication Industry Company® No. 2600—Paper ‘Bowater Paper Corp. 87050 Crown Zellerbach 197300 Hammermill Paper Co, 338500 International Paper 385000 ‘Kimberly-Clark Corp. 409900 Meade Corp. 465500 Riegel Paper Corp. 621500 St. Regis Paper Co. 1638200 Scott Paper Co. 644600 Union Camp Corp. 734018, Westvaco Corp. 795422 W It is interesting to note that Opinion 30 [AICPA, 1973], which significantly limits the discretion of man: agement regarding what could be classified as extraordi nary items, may have the effect of increasing the rela- tive importance of nonclassificatory smoothing in subse- quent attempts to-dampen variations of ordinary income. Copyright © 2001 All Rights Reserved 120 ‘The Accounting Review, January 1976 AppENDIx IT GLossaRy Variable Compustat DErINITIONS Symbol Variable Name Tiem No* %X_ Extraordinary expense per share Xi = [Xa — Xs) + Xe + Xu/Xe ‘Denoted ein equation 2) = 2 Nonrecurring enpense | 7 X; Nonrecurring expense net of taxes 48 Xe= Xr—Xa— Xo— Kw Xu— Xe FH Nonoperatingempense X Tax rate = —X: Xz Number of shares outstanding = %+ Operating income 13 Xz Depreciation 4 Xs = (Xis — Xu:)/Xis = Xto/Xua Xs Fited charges is Minority in Xu=Xr— Xs— Xe Xu (et X) EE Netinoome is Aaa Hu Income before tax = = 2 “El 8 2 Xa Ordinary income per shace lenoted Ex in equation 1) Xe = Xo/Xus Xie Operating income per share (denoted Z, in equation 1) ae = [ie + hs + X)1/Ke * Tn the case of nonavailability of a data item on the Xue = Xi/Xe Compustat tape He reteved fom the anal Appennix IIT Invustry REsutts ‘Tante 2 Suantary OF CORRELATION COEFFICIENT AND Reorusston CoErricreNts FOR THE PareR INDUSTRY (INTERNATIONAL PAPER AS LEADER) Level of Significance of Regression Coeficient & pValue <0 ‘Sign Smoothed | “Norma?” |——-_—_ Test Variable | Income | <.05 |.05~.1 Total Total | ‘one Ordinary | Time trend i 3 1 ut 0 | 0.0005 income | Leader trend | 8 1 1 10 0 ‘0010 Operating | Time trend | 3 5 8 3 1133 ‘income | Leader trend | 1 1 4 6 4 ‘370 ‘Taste 3 SuontaRy oF CORRELATION COEFFICIENT AND Regression CoRPPICTENTS oR Tie Cuxancats INpustey (Du Poxt as Lraper) ‘Level of Significance of Regression Coeficient b r<0 r>0 ‘Sign Smoothed Norma | $$ ——_ ——_ |} 0) oO Test Variable | Income <.05 |.05-1] S41 | Tota |

    You might also like