Working Paper Series

Classificatory income smoothing: the impact of FRS3

Vasiliki Athanasakou Norman Strong Martin Walker

Manchester Business School Working Paper No. 502 June 2006

Manchester Business School

Copyright 2006, Athanasakou, Strong and Walker. All rights reserved. Do not quote or cite without permission from the author. Manchester Business School The University of Manchester Booth Street West Manchester M15 6PB +44(0)161 306 1320 http://www.mbs.ac.uk/research/working-papers/default.aspx ISSN 0954-7401 The working papers are produced by The University of Manchester - Manchester Business School and are to be circulated for discussion purposes only. Their contents should be considered to be preliminary. The papers are expected to be published in due course, in a revised form and should not be quoted without the authors permission.

Author(s) and affiliation

Vasiliki Athanasakou Centre for Analysis of Investment Risk Manchester Business School The University of Manchester Crawford House Booth Street East Manchester, M13 9PL Tel: +44(0) 161 275 0227 Fax: +44(1) 161 275 0227 E-mail: Vasiliki.Athanasakou@mbs.ac.uk Web: http://www.mbs.ac.uk Norman Strong Accounting & Finance Division Manchester Business School The University of Manchester Crawford House Booth Street East Manchester, M13 9PL Tel: +44(0) 161 275 4006 Fax : +44(0) 161 275 4023 E-Mail : Norman.Strong@mbs.ac.uk Web :http://www.mbs.ac.uk Martin Walker Accounting & Finance Division Manchester Business School The University of Manchester Crawford House Booth Street East Manchester, M13 9PL Tel: +44(0) 161 275 4008 Email : Martin.Walker@mbs.ac.uk Web : http://www.mbs.ac.uk

JEL Classification
M41

Abstract
Financial Reporting Standard No 3 (FRS3) has regulated the reporting of financial performance by UK firms since 1993. FRS3 effectively outlawed extraordinary items, but provided for a clearer distinction between recurring and transitory income by giving firms considerable discretion over classifications of exceptional items and disclosures of alternative measures of EPS, thereby increasing the scope for classificatory income smoothing to highlight persistent profitability. We examine the impact of FRS3 on classificatory smoothing by UK firms and document a significant increase in this practice post-FRS3. Even though this increase coincides with a rise in the magnitude of negative non-recurring items, FRS3 removed the asymmetry in the distribution of non-recurring items that existed pre-FRS3, when negative items were more likely to be classified below the line of basic earnings. More importantly, we find that deviations of net income from expected earnings induce a significantly higher level of classificatory smoothing post-FRS3 and that removing non-recurring items results in more persistent earnings postFRS3 at the pre-exceptional level. Our results suggest greater use of classificatory choices to highlight sustainable profitability after the change in performance reporting regime.

How to quote or cite this document

Athanasakou, Vasiliki, Strong, Norman & Walker, Martin. (2006). Classificatory income smoothing: the impact of FRS3. Manchester Business School Working Paper, Number 502, available: http://www.mbs.ac.uk/research/working-papers.aspx.

Classificatory income smoothing: the impact of FRS3

Vasiliki Athanasakou,* Norman Strong, Martin Walker Manchester Business School, The University of Manchester

June, 2006

JEL classification: M41

Corresponding author: Centre for Analysis of Investment Risk, Manchester Business School, University of Manchester, Manchester M15 6PB, UK. Tel: ++ (0)161 2750227. Email: vasiliki.athanasakou@mbs.ac.uk. We gratefully acknowledge the comments of Professor Kenneth Peasnell and Dr. Steven Young (Lancaster University).

Classificatory income smoothing: the impact of FRS3

Abstract
Financial Reporting Standard No 3 (FRS3) has regulated the reporting of financial performance by UK firms since 1993. FRS3 effectively outlawed extraordinary items, but provided for a clearer distinction between recurring and transitory income by giving firms considerable discretion over classifications of exceptional items and disclosures of alternative measures of EPS, thereby increasing the scope for classificatory income smoothing to highlight persistent profitability. We examine the impact of FRS3 on classificatory smoothing by UK firms and document a significant increase in this practice post-FRS3. Even though this increase coincides with a rise in the magnitude of negative non-recurring items, FRS3 removed the asymmetry in the distribution of non-recurring items that existed pre-FRS3, when negative items were more likely to be classified below the line of basic earnings. More importantly, we find that deviations of net income from expected earnings induce a significantly higher level of classificatory smoothing postFRS3 and that removing non-recurring items results in more persistent earnings post-FRS3 at the preexceptional level. Our results suggest greater use of classificatory choices to highlight sustainable

profitability after the change in performance reporting regime.

Classificatory income smoothing: the impact FRS3

1. Introduction
We explore the impact of Financial Reporting Standard No3 (FRS3): Reporting Financial Performance on the practice of income smoothing via classifications of transitory items. FRS3 introduced a radical change in how UK firms report their financial performance. Before FRS3, SSAP3 required firms to report basic EPS on ordinary income, while SSAP6 offered a flexible definition of extraordinary items.1 This encouraged inconsistent classifications of items below ordinary income and classificatory smoothing through extraordinary items. It raised concerns among UK authorities that companies were increasingly classifying transitory items as exceptional if they were debits, and as extraordinary if they were credits. FRS3 mandated calculation of basic EPS on net income, disabling classifications of extraordinary items to smooth or increase EPS. At the same time, FRS3 contained new provisions for exceptional items, allowing for more informative distinctions between recurring and non-recurring income and between operating and non-operating income. It further allowed firms to disclose alternative EPS as long as they reconciled any alternative EPS to the basic figure, disclosed it consistently over time, and gave it no greater prominence in the annual report than basic EPS. These provisions enabled firms to smooth profit and loss sub-totals via classifications of non-recurring items, and had several implications for practice. First, FRS3s wide definition of exceptional items encouraged managerial judgment in classifying them in line with the nature of the firms activities. Second, firms could report alternative EPS on earnings before all exceptional items, not just those formerly classified as extraordinary. Third, FRS3s disclosure

requirements increased the transparency of classificatory choices. In all, the increased flexibility and transparency of classificatory choices under FRS3 allowed the provision of a more accurate measure of recurrent profitability. To predict the impact of FRS3 on classificatory smoothing, we focus on the information perspective of accounting choice (Holhausen and Leftwich, 1983) and assess the implications of FRS3s
FRS3, issued by the Accounting Standards Board (ASB), amended Statement of Standard Accounting Practice No 3 (SSAP3), issued by the ASBs predecessor, the Accounting Standards Committee (ASC), and superseded SSAP6.
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provisions on classificatory smoothing as a way of highlighting a better indicator of future profitability. Pre-FRS3 we examine classificatory smoothing via extraordinary items. Post-FRS3, in line with the gradual increase in the number of firms reporting alternative EPS on earnings before exceptional items (Choi, Lin, Walker, and Young 2005), we examine classificatory smoothing via exceptional items. We refer to extraordinary and exceptional items as classification items (CIs). Consistent with predictions, our results reveal an increase in the practice of classificatory smoothing post-FRS3. The rise is due to absolute unexpected earnings inducing a higher level of classificatory smoothing through exceptional items postFRS3. As a consequence, earnings before exceptional items appear significantly more persistent in the post-FRS3 period. These results are robust to alternative measures, test specifications, and explanations. Our study makes several contributions to the earnings management literature. First, we provide valuable information for accounting standard setters by shedding light on the impact of regulatory intervention on firms income smoothing practices. Consistent with our hypotheses, we find that FRS3 brought about an increase in the more transparent and less costly practice of classificatory income smoothing. Second, we extend the growing literature on disclosures of adjusted earnings (Bhattacharya, Black, Christensen, and Larson 2003, Choi et al. 2005). We find that within the UK, wider flexibility over classifications of exceptional items, enhanced disclosure of such items, and the opportunity to disclose alternative measures of performance, increased the practice of classificatory smoothing. Third, we extend prior research on the information content of adjusted earnings (Elliot and Hanna 1996, Bradshaw and Sloan 2002, Eames and Sepe 2003). Consistent with evidence on the superior value relevance of earnings before non-recurring items, we find that earnings adjusted for extraordinary and exceptional items are more persistent than net income, especially post-FRS3. Our results suggest that FRS3 enhanced the role of classificatory choices in highlighting permanent earnings. Fourth, we add to prior research on

classificatory smoothing, which in contrast to that on abnormal working capital accruals, focuses mainly on small datasets (Beattie et al. 1994, Godfrey and Jones 1999). We extend Beattie et al. (1994), who examine classificatory choices within an incentives-based framework, by providing consistent evidence based on a large sample. We also make a methodological contribution by developing a measure of the magnitude of classificatory smoothing that relaxes the assumption of a single smoothing object across firms. This is

important given that disclosure of alternative EPS is optional and firms may choose any level of profit as an alternative to net income. Exploring the impact of FRS3 on classificatory smoothing is timely in relation to current policy issues. In their current convergence project for reporting financial performance, the International

Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) have decided that financial statements should include either a single statement of comprehensive income, or two statementsan income statement and a statement of recognised income and expense (IASB 2005). The Boards have yet to determine a common approach for disaggregating financial information and the totals and subtotals to report in the income statement. At the same time, US regulators are concerned about increasing investor reliance on adjusted earnings (e.g. pro forma, Street earnings) disclosed in earnings announcements. In the light of these current developments, FRS3 offers a timely policy experiment. 2. Prior literature, institutional overview, and development of hypotheses 2.1 Literature review The income smoothing literature begins with the income smoothing hypothesis of Gordon (1964). Within his framework income smoothing arises as rational behaviour based on assumptions that: a) managers maximize their utility; b) earnings fluctuations and unpredictability of earnings determine market risk measures; c) the dividend payout ratio determines firm value; and d) managers utility depends on firm value. This literature makes the implicit assumption that the market is inefficient, i.e. that it functionally fixates on bottom line earnings, irrespective of the accounting choices involved in determining income. However, it is not necessary for the market to be inefficient for income smoothing behaviour to exist. It is sufficient that managers believe the market is inefficient. In either case, managers smooth income to reduce the actual or perceived riskiness of the firm arising from a cause-and-effect relation between earnings fluctuations and market risk (Moses 1987, p.366). Lev and Kunitzky (1974) provide evidence that the extent of income smoothing is correlated with both total and systematic risk. In contrast to this original income smoothing hypothesis, positive accounting theory (PAT), assumes the market is efficient and can detect smoothing behaviour (Watts and Zimmerman 1978, 1979). PAT rationalizes earnings management through positive contracting costs. Performance-related contracts

induce managers to make accounting choices to maximize their own wealth or to minimize agency costs with contracting parties (shareholders or debtholders). Alternatively, managers make accounting choices to reduce political costs associated with public visibility or regulation. The earliest smoothing study adopting a positive accounting framework is Moses (1987). Moses documents a significant association between the extent of smoothing and proxies for political costs and agency costs of equity. Holthausen and Leftwich (1983) propose the information theory of accounting choice as an alternative to the contracting theory. The information theory predicts that managers choose accounting techniques to convey information about expected future cash flows. The literature on the information theory identifies smoothing as an explicit strategy managers use to reveal their expectations (Schipper 1989). Thus, under the information theory, for income smoothing to be effective investors must observe managers accounting choices. We focus on the information perspective of accounting choice as it links to the regulatory framework for reporting financial performance. This is because the former addresses the issue of information asymmetry and limited communication between managers and the market (Fields, Lys, and Vincent 2001), while the latter determines the channels of communication. How do firms smooth income? Ronen and Sadan (1981) show that managers can smooth income either inter-temporally, by timing actual transactions to influence the income of particular periods, or via classifications of non-recurring items. Smoothing via classificatory items is feasible when the earnings figure managers seek to smooththe smoothing objectis a level of profit other than net income. Barnea, Ronen and Sadan (1976) and Ronen and Sadan (1981) argue that ordinary income is a desirable smoothing object, as transitory income components leave it unaffected and it dominates net income in predicting future profitability. Michelson, JordanWagner and Wootton (1995) find that firms that smooth ordinary income have significantly lower betas and higher equity market values. Using an incentives-based

framework, Beattie et al. (1994) examine classificatory smoothing via extraordinary items by UK firms. Consistent with Moses (1987), they find a significant association between the extent of classificatory smoothing, agency costs, and accounting risk. Godfrey and Jones (1999) verify the link between political costs and classificatory income smoothing. They use the redefinition of ordinary activities for Australian firms in 1989 to construct a measure of classificatory smoothing through extraordinary items and find that

managers of companies with high labour related political costs (high employee union membership) attempt to smooth net operating profit through classifications or recurring gains and losses. Recent research investigates adjusted earnings disclosures as a way of increasing the predictive power of reported earnings for future performance. Such disclosures enable a form of classificatory smoothing that is less restrictive than classificatory smoothing through extraordinary items, as managers may exclude any income components they consider transitory from the adjusted earnings figure. Evidence from Bradshaw and Sloan (2002) and Bhattacharya et al. (2003) suggests that pro forma earnings disclosures by US firms are more informative and more persistent than GAAP earnings. However, the adhoc nature of pro forma disclosures and the fact that they are outside the audited profit and loss statement have raised concerns about opportunistic classificatory choices. Doyle, Lundholm and Soliman (2003) and Landsman, Miller and Yeh (2006) substantiate these concerns with evidence that US firms remove value relevant items from pro forma earnings. The main difference in adjusted earnings reporting between the UK and the US is that FRS3 regulates UK practice. We consider this difference in examining classificatory smoothing by UK firms post-FRS3. Similar to Beattie et al. (1994) and Godfrey and Jones (1999), we use an incentives-based framework to examine classificatory smoothing. Unlike these two studies, which are constrained by the use of small datasets due to research design limitations,2 we use a large panel of UK firms, as we seek to examine the impact of FRS3 on the overall practice of classificatory smoothing. Apart from extending prior research, our study is the first to examine the impact of a change in financial performance reporting regime on classificatory income smoothing.

Beattie et al. (1994) use hand collected data from annual reports for 163 companies included in the 198990 survey of UK published accounts and reporting extraordinary and exceptional items. Godfrey and Jones (1999) use a sample of 58 Australian listed firms that restate their 1989 extraordinary item figure in their 1990 accounts, and have available data for 19801990.

2.2 FRS3 and classificatory choices By redefining ordinary activities3 to include the effects of any event irrespective of its frequency or unusual nature, FRS3 effectively outlawed extraordinary items. In effect, all items previously classified as extraordinary became exceptional items. The disclosure of exceptional items also changed substantially. Instead of being aggregated in one heading as under SSAP6, FRS3 required firms to distinguish between operating and non-operating exceptionals and to disclose operating exceptionals either on the face of the profit and loss statement or in a note. For each item, firms had to provide an adequate description to allow users to understand its nature (FRS319). FRS3 required disclosure of non-operating exceptionals under separate headings after operating profit and before interest. Non-operating exceptional items include profits or losses on the sale or termination of an operation, costs of a fundamental reorganization or restructuring and profits or losses on the disposal of fixed assets. The effect of FRS3 on exceptional items extended beyond these disclosure requirements. By allowing firms to disclose alternative EPS on other levels of profit, FRS3 enabled firms to remove exceptional items from alternative EPS and to highlight a more meaningful measure of earnings. FRS3 widened the scope for classificatory choices further through its broader definition of exceptional items. FRS3 defined exceptional items as any material items which derive from events or transactions that fall within the ordinary activities of the reporting entity and need to be disclosed by virtue of their size or incidence if financial statements are to give a true and fair view (FRS35). Apart from the three nonoperating exceptional items, this definition of exceptional items allowed UK firms to classify as exceptional not only highly unusual items falling within the ordinary activities of the firm but also items arising regularly, but being unusually large in the current year.4 In practice, firms disclose a variety of items as operating exceptional. An abbreviated list includes: reorganization costs (e.g. redundancy costs), restructuring costs, provisions for permanent diminution in the value of property and land, provisions for

Ordinary activities are any activities, which are undertaken by a reporting entity as part of its business and such related activities in which the reporting entity engages in furtherance of, incidental to, or arising from, these activities. They include the effects on the reporting entity of any event in the various environments in which it operates, including the political, regulatory, economic and geographical environments irrespective of the frequency or unusual nature of the events (FRS32). 4 In the latter case the exceptional effect on the results is not the whole amount of the item, but only the excess over a normal amount. For example, where a firm revises the estimated useful life of an asset, the firm can classify the excess amount of the revised depreciation charge over the old charge, if material, as exceptional.

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business rationalization, provisions for environmental liabilities, current asset write downs, provisions for losses in contracts, and goodwill written-off. Instead of a uniform list of exceptionals, FRS3 provided a definition of exceptional items that allowed managers to classify items according to the nature of the firms operations. 2.3 Development of hypotheses Classificatory choices have three advantages over inter-temporal income smoothing devices. First, they do not affect net income and are less likely to be challenged by auditors or trigger GAAP violations. Second, they do not flow through the accounting system and do not affect future period income. Third, they do not have tax implications. UK firms have been able to engage in classificatory smoothing since the introduction in 1974 of SSAP6, which required the separate disclosure of extraordinary items in the profit and loss statement after ordinary income. As EPS was calculated on ordinary income, UK firms could classify items below the line of basic EPS to smooth reported earnings. Empirical evidence documents the widespread use of

extraordinary items as an income-smoothing device (Smith 1992, Beattie et al. 1994). Pope and Walker (1999) report evidence of firms using extraordinary items to classify bad news earnings components, mainly in the form of write-offs of large transitory losses. Consistent with this evidence, Peasnell, Pope and Young (2000) report that pre-FRS3 the majority of extraordinary items reported by UK firms had the effect of increasing income, with their mean value approximating 2.7 million. FRS3 increased the flexibility of classificatory smoothing. Evidence that firms exploited this flexibility comes from Choi et al. (2005), who document a gradual increase in the number of firms reporting alternative EPS on pre-exceptional earnings levels. They find the main reason for disclosures of alternative EPS is the low information content of net income for sustainable performance. Furthermore, they document a gradual increase in the magnitude of negative exceptional items post-FRS3, due mainly to the growth of negative operating exceptionals. This evidence is consistent with an increase in total CIs post-FRS3 resulting from the desire to report a better indicator of sustainable profitability. In addition to increasing flexibility, FRS3s disclosure requirements increased the transparency of classificatory smoothing, allowing investors to identify and assess the adjustments made to arrive at the

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alternative earnings figure. Higher disclosure helps investors and analysts identify core profitability and make more accurate forecasts of future performance (Penman 2003). Acker, Horton, and Tonks (2002) examine the effect of FRS3 on analyst forecast errors based on pre-exceptional levels of earnings.5 They find that after the first year of FRS3, pre-exceptional earnings are associated with lower forecast errors. Lin (2002) examines whether analyst forecasts reflect the post-FRS3 information in unexpected earnings components. He finds that analysts revise their current and future earnings forecasts to impound

information contained in non-recurring items and to improve the accuracy of their predictions. A significant implication of higher transparency is that it constrains opportunistic classificatory choices, as it increases the likelihood that investors can detect attempts to remove income components opportunistically. Opportunistic firms may prefer less transparent income smoothing devices. However, for firms wishing to convey a more sustainable measure of performance, classificatory smoothing through FRS3 provisions offers an efficient communication channel. Higher flexibility and disclosure of classificatory choices post-FRS3 allow for an increase in classificatory smoothing and the provision of a better metric of persistent profitability. Accordingly, we predict that FRS3 increased the practice of classificatory smoothing by UK firms to highlight recurrent profitability and to signal future performance. We form two hypotheses, the first on the overall effect of FRS3 on the practice of classificatory smoothing, the second on the incentive underlying this effect, which stems from a consequence of income smoothing, Hypothesis 1: FRS3 increased the practice of classificatory smoothing by UK firms. Hypothesis 2: FRS3 increased the use of classifications of non-recurring items to highlight persistent earnings.

Analysts forecast earnings before exceptional items post FRS3, in contrast to the pre-FRS3 regime in which analysts excluded only extraordinary items.

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3. Research design 3.1 Measuring classificatory smoothing

We measure classificatory smoothing as the extent to which removing extraordinary and exceptional items (CIs) reduces the variability of reported earnings. We start by constructing an index of income smoothing following Eckel (1981) as,

SI =

EARNINGS REV

where EARNINGS is the standard deviation of earnings and REV is the standard deviation of sales revenue. Scaling by sales volatility controls for economic performance across firms.6 Low values of SI indicate that, ceteris paribus, managers smooth reported earnings. We calculate the ratio at the firm level and separately for pre- and post-FRS3 periods. We follow the framework of Ronen and Sadan (1981) on the interrelation between smoothing objects and smoothing dimensions to measure the level of classificatory income smoothing. In this framework, firms can smooth net income only inter-temporally, but can smooth levels of earnings other than net income by a combination of inter-temporal and classificatory smoothing (see the Appendix). Based on this framework we calculate the smoothing index on net income (EARN ) and on alternative

levels of earnings that are potential smoothing objects. We calculate a classificatory smoothing index
(CSI ) by subtracting the smoothing index of the smoothing object from the smoothing index of net

income.

Positive values of CSI capture smoothing of reported earnings through classifications of

extraordinary and exceptional items. We calculate CSI separately for pre- and post-FRS3 periods. Pre-FRS3, consistent with prior research (Beattie et al. 1994), we assume the smoothing object is ordinary income before extraordinary items (EARNbXI ), communicated to investors through basic EPS. We calculate smoothing indexes of EARN calculations.
( SI 1 ) and EARNbXI ( SI 2 ).

Table 1 describes the

CSI is the difference between SI 1 and the minimum of SI 1 and SI 2 , and captures the

magnitude of smoothing resulting from classifications of extraordinary items.

We repeat the analysis using cash sales (total revenue minus change in receivables) as the denominator to subtract the revenue component that may be subject to artificial smoothing (through accruals). Our main results remain unaltered using this alternative specification.

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Identifying the smoothing object pre-FRS3 is straightforward, but this is not the case post-FRS3. The option to disclose alternative EPS on levels of earnings other than net income creates the possibility of multiple smoothing objects. We examine two smoothing objects besides EARN : earnings before nonoperating exceptional items (EARNbNOEI ) and earnings before all (both non-operating and operating) exceptional items (EARNbEI ). For the post-FRS3 period we consider two scenarios. In the first, we assume firms smooth EARN , EARNbNOEI , or EARNbEI. We identify the least volatile figure as the
smoothing object. We calculate smoothing indices for EARN ( SI 1 ) , EARNbNOEI ( SI 3 ) and EARNbEI
( SI 4 ). CSI is the difference between SI 1 and the minimum of SI 1 , SI 3 , and SI 4 and captures the

magnitude of smoothing resulting from classifications of either non-operating exceptional items when the smoothing object is EARNbNOEI , or all exceptional items, when the smoothing object is EARNbEI. This scenario accommodates evidence by Choi et al. (2005) of a simultaneous increase in the frequency of alternative EPS disclosures from 1994 to 1996 and a gradual increase in operating exceptional charges. In the second scenario, we assume firms smooth either EARN or EARNbNOEI. We use the same method to identify the smoothing object amongst the two alternatives. CSI is the difference between SI 1 and the minimum of SI 1 and SI 3 and captures the magnitude of smoothing resulting from classifications of non-operating exceptional items when EARNbNOEI is the smoothing object. EARNbNOEI is similar to headline earnings that the IIMR (Institute of Investment Management and Research) introduced in 1993 as an earnings metric that excludes all exceptional items formerly classified as extraordinary and exceptionals that relate to capital values. To this extent, the second scenario is mostly plausible for the initial period following the implementation of FRS3.

3.2 Research design for classificatory smoothing

To test the impact of FRS3 on the level of classificatory smoothing we use descriptive statistics and the following multivariate specification,

CSI i , p = a0 + a1 FRS 3i , p + a2 DIVERGENCEi , p + a3 FRS 3 DIVERGENCEi , p + a4GAINLOSS i , p + a5 PERMLOSSi , p + a6 RISK ( )i , p + a7 LEVi , p + a8 SIZEi , p + a9 PI i , p + a10 PI i , p + a11 LI i , p + ui , p , i = 1,..., N ; p = 1, 2 (1)

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In equation (1), p = 1 refers to the pre-FRS3 period, p = 2 to the post-FRS3 period. FRS 3 is a GAAP regime indicator, taking the value 0 when p = 1 and 1 when p = 2. Equation (1) is therefore a panel regression involving a cross-section of N firms, each with two observations (pre- and post-FRS3). We discuss the remaining regressors below. We estimate equation (1) for each scenario of the post-FRS3 period separately. We calculate all explanatory variables annually and use pre- and post-FRS3 averages. Our predictions focus on the information perspective of income smoothing. By smoothing income, managers produce a stable and predictable earnings stream to facilitate forecasts of future profitability. In this signalling framework, Moses (1987) argues that managers seek to report earnings that are closer to expectations and that incentives to smooth income increase with the divergence between actual and expected earnings. Accordingly, we expect a positive association between CSI and the extent to which pre-managed earnings diverge from expectations. We introduce DIVERGENCE as the absolute value of unexpected earnings to capture this effect.7 8 To the extent high deviations from expected earnings induced classificatory smoothing pre-FRS3, we expect a 2 to be positive. If UK firms use classifications of nonrecurring items to a greater extent post-FRS3 to report earnings closer to expectations and highlight persistent profitability, we expect the positive association between DIVERGENCE and CSI to be more pronounced post-FRS3. We add an interaction term, FRS 3 DIVERGENCE , to capture this structural shift. Consistent with our second hypothesis, we expect a3 to be positive in both scenarios. The practice of classificatory smoothing relies on the firms propensity to highlight adjusted earnings metrics. We add two proxies to capture this. Lougee and Marquardt (2004) find that firms reporting GAAP losses are more likely to disclose pro forma earnings. This incentive is particularly keen when adjusted earnings are positive, as managers wish to highlight an indicator of the firms earnings generating ability that is unaffected by large transitory losses. Choi et al. (2005) document a positive association between the likelihood of alternative EPS disclosure and the frequency of firms with net income losses and positive adjusted earnings. As a result, we add an indicator, GAINLOSS, of cases where net income is negative while adjusted earnings are positive as a proxy for the inclination to highlight preSection 4.2 gives the precise definitions of all variables. DIVERGENCE also serves as a control, as deviations of pre-managed earnings from expectations affect the remaining smoothing incentives. Moses (1987) provides evidence that larger deviations from expectations are necessary to induce certain smoothing incentives (e.g. political costs).
8 7

15

exceptional earnings. We expect a positive association between GAINLOSS and CSI . Choi et al. (2005) further argue that firms are unlikely to disclose an adjusted earnings metric when this metric is negative as it is less likely to be informative about their future prospects. Consistent with their claim, they find that the probability of alternative EPS disclosure is lower when adjusted earnings are negative. Accordingly, as a second proxy we add an indicator of negative pre-exceptional earnings, PERMLOSS , and expect a negative association between PERMLOSS and CSI . In addition to dampening deviations from expected earnings to signal future performance, managers smooth income to reduce actual or perceived riskiness resulting from the relationship between earnings volatility and risk (Moses 1987, Lev and Kunitzky 1974, Beattie et al. 1994, Michelson et al. 1995). Accordingly, we include market risk ( RISK ( )) in equation (1). We expect a positive association between CSI and RISK ( ), as riskier firms have greater incentives to smooth earnings. Consistent with PAT, we add gearing (LEV ) and size (SIZE ) as proxies for agency costs of equity and political costs. More highly levered firms are more likely to smooth ordinary (or operating) income to avoid fluctuations that might breach debt covenants, especially in relation to the interest cover ratio. Even in the absence of interest cover constraints, managers may smooth income to create an impression of financial stability. Therefore, we expect a positive association between CSI and LEV . Larger firms have higher incentives to dampen earnings fluctuations and minimize the costs of potential external intervention, thus we expect a positive association between CSI and SIZE. Following Ashari, Koh, Tan and Wong (1994), we control for firm profitability (profitability index, PI ). Fluctuations in income have a more severe impact on low profitability firms giving them a stronger motive to smooth income. We also control for the change in profitability ( PI ) in response to Whites (1970) evidence that firms with declining profitability tend to smooth income. Finally, removing a classification item alters both the level and the variability of reported earnings. Moses (1987) provides evidence that managers are concerned about the joint effect of their accounting choices on earnings levels and variability. Since managers are concerned about both effects and some of the factors in our model could motivate managers to adjust the level of earnings, we add a control for the impact that removing CIs has on the level of reported income (LI ). Adding LI is particularly important in

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view of the evidence of Beattie et al. (1994) that incentives to smooth depend on the size of the effect of CIs on the level of earnings (i.e. this effect should reach a specific level to trigger smoothing behaviour). Including LI also controls for the ability to engage in classificatory smoothing. This is because

classifications of non-recurring items are to some extent determined by events giving rise to their occurrence (e.g. restructurings, divestitures, events triggering fair value adjustments and changes in accounting estimates etc.). Because CSI takes only zero and positive values, equation (1) belongs to the class of censored regression models. Even though CSI is a continuous variable over strictly positive values, it takes the value zero with positive probability, in the sense that for some managers the optimal choice may be zero classificatory smoothing. This type of response variable is a corner solution outcome (Wooldridge 2002). Accordingly, we estimate the coefficients of equation (1) using a corner solution Tobit model.

3.3 Earnings persistence tests

To explore whether an increase in classificatory smoothing post-FRS3 increases the persistence of pre-exceptional earnings and highlights a superior indicator of sustainable profitability, we complement our multivariate analysis with earnings persistence tests. First, we assess the extent to which removing

classification items increases the persistence of reported earnings in the pre- and post-FRS3 periods. Second, we test whether this effect increases as a result of the introduction of FRS3. We initially use earnings persistence regressions for different levels of earnings (EARNADJ ) separately for pre- and postFRS3 periods and then add an interaction term between contemporaneous earnings and FRS 3 to capture any structural break in earnings persistence after the enforcement of FRS3

EARNADJ i ,t +1 = 0 + 1 EARNADJ i ,t EARNADJ i ,t +1 = 0 + 1 EARNADJ i ,t + 2 FRS 3 EARNADJ i ,t + vi ,t

(2)

(3)

We use three measures of EARNADJ:

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Earnings level 1. EARNADJ1 2. EARNADJ 2 3. EARNADJ 3

Definition Pre-FRS3: Earnings before extraordinary items (EARNbXI ) Post-FRS3: Earnings before non-operating exceptional items (EARNbNOEI ) Pre-FRS3: Earnings before extraordinary items (EARNbXI ) Post-FRS3: Earnings before all exceptional items (EARNbEI ) Pre-FRS3: Earnings before extraordinary and exceptional items ( EARNbXI & EI ) Post-FRS3: Earnings before all exceptional items (EARNbEI )

Consistent with the second hypothesis, we expect 2 to be positive for all three measures.

4. Sample and definition of variables

4.1 Sample We use data for all UK (dead and live) non-financial listed firms from Datastream for the period 1986 until the enforcement of FRS10 in December 1998. Choosing FRS10 as the sample period cut-off is important due the potential effect of FRS10 on classificatory smoothing. FRS10 required UK firms to charge amortization of goodwill and intangibles assets to the income statement, providing an additional motive to managers to disclose alternative EPS on pre-exceptional earnings in order to deduct the substantial charge of amortization. As our objective is to examine the effect of FRS3, the sample period ends with the introduction of FRS10 (23/12/1998).9 We employ a balanced sample to assess whether there is a structural break in the practice of classificatory smoothing caused by the introduction of FRS3. With a balanced sample design, each firm has at least one observation in both the pre- and post-FRS3 period. This way, each sample firm serves as its own control, minimising the effects of temporal differences in sample composition on the results (Peasnell et al. 2000). The balanced sample includes 9,459 observations for 993 firms. To calculate firm and period specific classificatory income smoothing indices we keep firms with at least two observations in both the pre- and post-FRS3 periods. The final sample is 914 firms and 9,222 firmyear observations.

To the extent firms anticipated FRS10, this may have encouraged them to release an alternative EPS on earnings before all exceptional items before FRS10. Thus, there is a risk of capturing part of the FRS10 effect on the practice of classificatory smoothing. As FRS10 was issued in December 1997, the risk relates mainly to 1998 observations. Our main results are robust to removing these observations.

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4.2 Definition of variables For the empirical analysis we use five earnings measures: earnings after extraordinary items (EARN ), earnings before extraordinary items (EARNbXI ), earnings before extraordinary and exceptional items ( EARNbXI &EI ), earnings before non-operating exceptional items (EARNbNOEI ), and earnings before all exceptional items (EARNbEI ). 10 DIVERGENCE is the absolute value of the difference between pre-managed earnings and expected earnings scaled by total sales (DS104). We use EARN as premanaged earnings, since classificatory choices do not affect net income. For expected earnings, we assume a random walk model and choose the earnings level in line with the smoothing object. Pre-FRS3 expected earnings is lagged EARNbXI . Post-FRS3, expected earnings is either lagged EARNbNOEI or lagged EARNbEI. Pre-FRS3 GAINLOSS equals 1 when the firm reports net income losses ( EARN < 0) and ordinary profits ( EARNbXI > 0), 0 otherwise. Post-FRS3 GAINLOSS equals 1 when the firm reports net income losses ( EARN < 0) and the smoothing object is positive ( EARNbNOEI > 0 or EARNbEI > 0), 0 otherwise. Pre-FRS3 PERMLOSS equals 1 if EARNbXI < 0, 0 otherwise. Post-FRS3 PERMLOSS equals 1 if the smoothing object is negative ( EARNbNOEI < 0 or EARNbEI < 0), 0 otherwise. RISK ( ) is the beta coefficient from firm specific regressions of stock return on the FTSE All Share Index return over a 60-month window ending at the financial year end in question. Consistent with Peasnell et al. (2000), we measure leverage (LEV ) as the book value of debt over total assets (DS1301/DS392). For
SIZE we use decile portfolios formed each year by sorting observations into 10 groups based on lagged

market value of equity and assign values of 0 to firms in the smallest decile through to 9 for firms in the largest decile. For the profitability index (PI ) we use decile portfolios based on net income scaled by

10

Using Datastream account codes (DS), pre-FRS3 EARN is DS625 + DS193, where DS625 is earnings before extraordinary items and DS193 is total extraordinary items. Post-FRS3 EARN is DS1087, which is earnings after extraordinary items. EARNbXI is DS625. EARNbXI&EI is DS625 DS194, where DS194 is total exceptional items. Similar to Gore et al. (2002), we calculate EARNbNOEI as DS1087 (DS1083 DS1094 DS1097) where DS1083 is total special or non-operating exceptional items and includes profits or losses on sale or termination of operations, costs of fundamental reorganisations or restructuring, and profits or losses on sale of fixed assets; DS1094 is tax on total non-operating exceptional items; and DS1097 is the minority interest on non-operating exceptional items. EARNbEI is DS1087 DS194.

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lagged assets. For the change in profitability index (PI ) we use decile portfolios based on the annual change in net income scaled by lagged assets. We measure the level impact of classification items (LI ) as, Pre-FRS3: The income-increasing (decreasing) effect of negative (positive) extraordinary items ( XI ). 11 XI is DS193. Post-FRS3: Scenario A: The income-increasing (decreasing) effect of either negative (positive) nonoperating exceptionals ( NOEI ) or negative (positive) exceptionals ( EI ) in line with the smoothing object. EI is DS194. Scenario B: The income-increasing (decreasing) effect of negative (positive) non-operating exceptional items ( NOEI ). NOEI is DS1083 DS1094 D1097. LI is scaled by lagged assets and is zero when the classificatory smoothing index (CSI ) is zero.12

We winsorize all variables at the 0.5% and 99.5% percentiles.

5. Results

5.1 The effect of FRS3 on classificatory income smoothing 5.1.1 Descriptive statistics Table 2, Panel A reports descriptive statistics for extraordinary items ( XI ) and exceptional items
(EI ) for the pre-FRS3 period and for non-operating exceptional items (NOEI ) and operating exceptional

items (OEI ) for the post-FRS3 period. Results show that pre-FRS3 mean XI (0.004) and EI (0.003) are both negative and significant. Contrary to the perceptions of regulators, the results do not show a dominance of negative extraordinary items and positive exceptional items pre-FRS3. Similar to the preFRS3 period, mean NOEI (0.007) and OEI (0.006) post-FRS3 are negative and significant but are larger in magnitude. Since FRS3 treats most former XI as NOEI , we calculate their mean difference as

Datastream reports exceptional and extraordinary items as negative when they are costs or losses, and positive when they are revenues or profits. 12 We repeat the main tests using deciles portfolios based on LI, to account for the negative skewness of classification items. The core results remain using this alternative measure.

11

20

well as the mean difference between EI pre-FRS3 and OEI post-FRS3. Both differences are significant, indicating an increase in the magnitude of negative exceptional items post-FRS3. To provide information on variation over time, Table 2, Panel B reports annual statistics for XI and EI pre-FRS3 and for NOEI and OEI post-FRS3. Analysis of mean XI indicates increasingly negative values starting in 1990 and reaching 0.011 in the 92/93 pre-FRS3 observations. These results are consistent with prior evidence on the income-increasing role of XI reported by UK firms (Smith 1992, Pope and Walker 1999, Peasnell et al. 2000). As mean earnings before extraordinary items in the 92/93 pre-FRS3 observations (not tabulated) is 0.031, the income-increasing effect of XI for this period is substantial. EI displays a similar pattern to XI , despite the pre-FRS3 position of exceptional items above ordinary income. Negative values of mean EI start in 1990 and reach 0.010 in the 92/93 pre-FRS3 observations.13 Results show that NOEI and OEI are negative throughout the post-FRS3 period, totalling
0.015 immediately after the implementation of FRS3 and peaking at 0.022 in 1998. Negative averages

for both NOEI and OEI post-FRS3 are consistent with evidence of firms disclosing alternative EPS reported by Choi et al. (2005). Results further indicate that even though directly following the

implementation of FRS3 the ratio of OEI to NOEI is 0.50 (0.005/0.010), the ratio is 2 (0.006/0.003) in 1997 and 1 (0.011/0.011) in 1998. This suggests an increase in the relative magnitude of negative
OEI , as Choi et al. (2005) also document.

Table 2, Panel C reports the frequency of positive, negative, and zero XI and EI for the pre-FRS3 period and of NOEI and OEI for the post-FRS3 period. In Panel D we repeat the analysis by year. For both XI and NOEI , the majority of observations are zero in both periods (55 and 53 percent), indicating that a substantial proportion of firms do not report these items. For firms disclosing such items, the majority (67 percent) of XI are negative. A binomial (two-sided) test for the difference in frequencies of positive and negative extraordinary items conditional on non-zero disclosures is highly significant, confirming the predominance of extraordinary losses. This holds for most pre-FRS3 accounting periods. In contrast, NOEI has roughly equal frequencies of positive and negative values. A binomial test for the

13

The economic recession prevailing in the UK in the early 1990s affects trends for this period. The average growth rate of real GDP for 19901993 was approximately 0.59 percent compared to 4.44 percent for 19861989.

21

overall post-FRS3 period does not reject equality of the two frequencies ( p = 0.805). Annual analysis provides evidence of asymmetry in the distribution of NOEI only in the first period reporting under FRS3 and in 1997. For EI and OEI the frequency of zero observations is 19 and 17 percent, suggesting that only a small proportion of the population do not disclose such items. Where firms report EI pre-FRS3, the majority are positive (57 percent). The binomial test is significant, confirming EI is positively skewed. Therefore, focusing on the signs of the items, the evidence appears to justify regulatory concerns over the prevalence of negative XI and positive EI pre-FRS3. Analysis by year in Panel D shows that positive skewness is not evident in the distribution of EI in the two periods preceding the introduction of FRS3. The shift in frequencies might be due to restructuring costs, since in 1991 the ASB required UK firms to classify these costs as exceptional rather than extraordinary. Finally, similar to the pattern of NOEI , OEI appears equally distributed between positive and negative values post-FRS3. A binomial test for the overall post-FRS3 period does not reject equality of the two frequencies ( p = 0.332). FRS3 therefore appears to have successfully removed the skewness in the distribution of classification items. Analysis by year, however, shows that in 1997 and 1998 the majority of OEI are negative. The gradual rise in the frequency of negative operating exceptions might reflect managerial attempts to release an alternative EPS on earnings before all exceptional items in anticipation of FRS10. Moving to the core empirical analysis for the first hypothesis, Table 3 reports the mean and median values of the classificatory smoothing index (CSI ) partitioned into the pre- and post-FRS3 periods. PreFRS3, CSI measures income smoothing from classifications of XI . Post-FRS3, the index varies with the scenario we examine. In Scenario A, CSI measures income smoothing from classifications of either NOEI or both NOEI and OEI . In Scenario B, CSI measures income smoothing from classifications of NOEI . For the pre-FRS3 period, Table 3 shows a significant mean and median CSI of 0.063 and 0.004. For the majority of firms (527/914 = 58%) CSI is positive. These results confirm the smoothing property of XI for ordinary income documented by Beattie et al. (1994). Post-FRS3 in Scenario A, mean and median CSI increase to 0.157 and 0.023. The difference across periods is highly significant for both the mean and the median. The number of uncensored observations (CSI > 0) increases to 715, indicating a

22

substantial rise in the frequency of firms engaging in classificatory smoothing via all exceptional items post-FRS3. In Scenario B, mean and median CSI increase to 0.102 and 0.006. The increase in mean is significant. The frequency of uncensored observations (CSI > 0) in this scenario increases to 550. These results provide evidence consistent with our first hypothesis of an increase in classificatory income smoothing post-FRS3, especially in Scenario A. Table 4 reports descriptive statistics for the control variables of equation (1) partitioned into the pre- and post-FRS3 periods. Post-FRS3 there is evidence of a significant decrease in DIVERGENCE , especially in Scenario A, the frequency of firms with negative pre-exceptional earnings

(PERMLOSS, Scenario A) and RISK ( ), and of a significant increase in the frequency of firms with preexceptional earnings and net income losses (GAINLOSS, Scenario A). The impact of CIs on the level of reported earnings (LI ) is significantly positive, reflecting the income-increasing effect of CIs in both periods and in both scenarios. Calculated in line with Scenario A, there evidence of a significant rise in the income-increasing effect of CIs post-FRS3. 5.1.2 Multivariate analysis Table 5 reports Tobit regression results for the effect of FRS3 on CSI . Model 1 contains the results of estimating equation (1) in Scenario A. As is common for corner solution applications we also report the partial effects (economic significance) of the explanatory variables. DIVERGENCE is positive and significant (0.278, t = 2.41), suggesting a positive association between deviations of net income from lagged ordinary income and classificatory smoothing via extraordinary items pre-FRS3.

FRS 3 DIVERGENCE is positive and significant (0.702, t = 2.88), increasing the coefficient on DIVERGENCE to 0.980 post-FRS3. This increase suggests that deviations of net income from lagged earnings before all exceptional items induce a significantly higher level of classificatory smoothing postFRS3.
GAINLOSS , PERMLOSS , RISK ( ), LEV, SIZE , PI and PI are all significant and in

accordance with predicted signs. LI is positive and significant (3.863, t = 6.04) , indicating that increasing

23

adjusted earnings through income-increasing CIs (e.g. restructuring costs, losses from disposals of assets, exceptional operating costs) also result in smoother earnings.14 Model 2 in Table 5 reports the results of estimating equation (1) in Scenario B. FRS 3 DIVERGENCE is positive and significant (0.373, t = 2.15), suggesting that deviations of net income from lagged earnings before non-operating exceptional items induce a higher level of classificatory smoothing post-FRS3. The magnitude of the coefficient on FRS 3 DIVERGENCE is substantially lower than in Model 1. In summary, the results in Table 5 provide evidence in favour of our second hypothesis of an increase in classificatory income smoothing post-FRS3 to report earnings closer to expectations and highlight recurrent profitability. The increase is evident where we allow a combination of smoothing objects between EARN and EARNbNOEI in Scenario B and is substantially higher when we allow for the likelihood that some firms smooth EARNbEI in Scenario A.

5.2 Additional analyses 5.2.1 Refining the estimation of CSI For the initial calculation of CSI we require firms to have at least two observations in both the preand post-FRS3 periods. This is the minimum requirement to calculate standard deviations. For more efficient calculation of standard deviations, we repeat the analysis of Table 5 on a subset of 609 firms approximately 67 percent of the original samplewith at least five observations in each period. Table 6 reports the regressions results. The coefficients on FRS 3 DIVERGENCE are positive and significant in both scenarios ( 1.410, t = 3.24 in Scenario A and 0.754, t = 2.41 in Scenario B), and higher than those in Table 5. Consistent with our main predictions, the results provide strong evidence of a significant rise in the level of classificatory smoothing post-FRS3 to reduce deviations of net income from expectations.

14

By construction, CSI is left censored so we eliminate cases where classificatory choices magnify the volatility of reported earnings. As a result, we are unable to capture the effect of income-increasing CIs that increase the variability of earnings. This biases results against finding a negative association between LI and CSI. To ensure robustness of this result, we redefine CSI to include negative values and define LI accordingly. We then repeat the regression analysis using OLS instead of censored Tobit. The result of a positive association between CSI and LI remains. All other explanatory variables, with the exception of RISK ( ), remain significant and in accordance with predicted signs.

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5.2.2 Other structural shifts To test whether structural breaks for any of the remaining drivers of variation in classificatory smoothing confound our core findings, we allow for interaction terms between these drivers and FRS 3. Table 7 reports the results. FRS 3 DIVERGENCE remains positive and significant under both scenarios (0.667, t = 2.46 in Scenario A and 0.329, t = 1.70 in Scenario B). There is also evidence of a structural shift in LI . In Scenario A the coefficient on LI increases from 2.056 pre-FRS3 to 4.515 (2.056 + 2.459) post-FRS3. The shift is similar in Scenario B and is more pronounced when we repeat the analysis for firms with at least five observations in both the pre- and post-FRS3 period. The increase in the positive association between LI and CSI suggests that firms use CIs to a greater extent post-FRS3 to increase and smooth reported earnings simultaneously. 5.2.3 Alternative explanation for the increase in classificatory smoothing The main problem in measuring classificatory smoothing is that the magnitude and incidence of CIs is primarily due to business fundamentals. Failure to control for these factors can result in For example, an increase in business

measurement error in the proxy for classificatory smoothing.

restructurings in the post-FRS3 period could lead to an increase in both the magnitude of negative nonoperating exceptional items and the extent to which these items reduce the variability of alternative measures of performance. Thus, an apparent increase in the magnitude of classificatory income smoothing could reflect an increase in the frequency of real events. Elliott and Hanna (1996) document a dramatic increase in the frequency of negative special items for US firms for the period 19801994, despite the same reporting standard governing the disclosure of special items throughout the period. The authors point out that the rising trend coincides with an increasing frequency of corporate restructurings during the 1980s. To limit the risk of an increase in the frequency of real events driving our results, we scale earnings volatility by revenue volatility in calculating the smoothing indices. Gore, Pope and Singh (2002) argue that revenues also reflect the effect of events such as mergers, acquisitions, and other structural business changes, which give rise to non-operating exceptional items. The fact that the documented increase in negative exceptional items post-FRS3 results mainly from gradual growth in the relative magnitude of

25

operating exceptional items further mitigates this risk. Events giving rise to operating exceptional items are even more likely to be reflected in revenue. As for restructuring charges, which are a major component of non-operating exceptional items, prior evidence in the UK documents a decreased frequency of corporate restructurings in the years following the introduction of FRS3 up until 1998 (Mak 2002). As an additional robustness check on our control for operating performance, we recalculate CSI based on smoothing indices that scale the standard deviation of earnings by the standard deviation of operating cash flows. Controlling for cash flows captures the effect of events giving rise to exceptional items reflected in costs instead of revenue. We repeat the core tests with the alternative CSI measure and find consistent results in both scenarios. 5.2.4 Repeating the analysis for firms disclosing alternative EPS In calculating CSI for the post-FRS3 period we assume the least volatile earnings number is the firms smoothing object. This might be a misleading criterion if the firm does not disclose this number to investors as an alternative EPS.15 On the other hand, lack of an alternative EPS does not necessarily mean that a firms smoothing object is basic EPS. Ronen and Sadan (1981) argue that the smoothing object is the variable managers perceive to have the greatest impact on investors actions. The original intention of the ASB when issuing FRS3 was to provide users with a range of important components of performance to enable them to convert net income to a more sustainable performance indicator and to form better informed expectations about future results and cash flows. To the extent managers are confident that analysts and investors make the necessary adjustments to arrive at core earnings, they may smooth a profit and loss subtotal without reporting alternative EPS on this number. Shortly after the enforcement of FRS3

(September 1993) the IIMR introduced headline earnings, an income figure focusing on a companys trading performance and less volatile than net income. For the initial period following the introduction of FRS3, the EPS that analysts forecasted was headline earnings (Acker et al. 2002). In two post-FRS3

15

This is a plausible scenario especially for the period directly following implementation of FRS3. As disclosing alternative EPS was not mandatory under FRS3, and as it was inevitably not an established policy in the initial period, some firms may have been reluctant to make such disclosures immediately. Possible reasons are confusion over the new definitions, uncertainty over the disclosure choices of other firms, and the time needed to choose an alternative level to disclose consistently over time.

26

accounting periods, 1993 and 1996, Lin and Walker (2000) find that headline earnings were more value relevant for stock prices than basic EPS. To further investigate this issue, we repeat the core tests of the first hypothesis on a subset of firms that disclose alternative EPS post-FRS3. We use data on alternative EPS disclosures in 1996 for the 500 largest (based on market capitalization) UK listed non-financial firms.16 From the initial number of 254 disclosers of alternative EPS,17 197 satisfy the criteria for the original sample. Table 8 reports the mean and median CSI partitioned into the pre- and post-FRS3 periods. Pre-FRS3, mean and median CSI are 0.071 and 0.016. Post-FRS3, mean and median CSI increase to 0.190 and 0.068 in Scenario A, and 0.127 and 0.026 in Scenario B. While the increase in mean CSI is significant in both scenarios, the increase in median CSI is significant only in Scenario A. The frequency of firms with positive CSI in Scenario A rises by 13% ((164 139) / 197) post-FRS3. The respective increase in Scenario B is only 4%, suggesting that a great proportion of firms disclosing alternative EPS smooth income through all and not just nonoperating exceptional items. Regression results, reported in Table 9, show that FRS 3 DIVERGENCE is positive and significant in both scenarios. The coefficients on FRS 3 DIVERGENCE (4.274, t = 5.74 in Scenario A and 2.122, t = 2.52 in Scenario B) substantially exceed those in Table 5 (0.702 and 0.373). In Table 10 we extend the analysis to allow for interactions between the remaining drivers of the variation in CSI and
FRS 3. FRS 3 DIVERGENCE remains positive and significant in both scenarios (4.115, t = 6.70 in

Scenario A and 2.195, t = 2.41 in Scenario B). We find evidence of structural shifts in SIZE (only in Scenario A) and LI . The coefficient on SIZE increases from 0.008 pre-FRS3 to 0.041 (0.008 + 0.033) post-FRS3, consistent with a more pronounced positive association between size and classificatory smoothing post-FRS3. The coefficient on LI switches from negative (2.677) pre-FRS3, to positive (2.677 + 8.476 = 5.799) post-FRS3. The shift is similar in Scenario B. So, while pre-FRS3 the level and smoothing effect of removing CIs on reported earnings work in opposite directions, post-FRS3 incomeincreasing CIs also result in smoother earnings.
16 17

We thank Dr Young-Soo Choi (Lancaster University) for providing his data on disclosures of alternative EPS. This is approximately 50% of the top 500 UK firms. We repeat the analysis for firms disclosing alternative EPS in the first post-FRS3 financial statements published in 1993/1994 (approximately 38% of the top 500 UK firms). The core results remain.

27

To test whether absolute unexpected earnings induce a greater increase in classificatory smoothing post-FRS3 for firms disclosing alternative EPS in 1996 relative to the remaining firms in the sample, we run tests on the full sample adding an interaction term between an indicator of disclosure of alternative EPS (DIS ) and FRS 3 DIVERGENCE. Table 11 reports the regression results. While FRS 3 DIVERGENCE remains significant in both scenarios (0.730, t = 3.27, in Scenario A and 0.393, t = 2.26, in Scenario B) DIS FRS 3 DIVERGENCE is also significant (2.403, t = 3.60, in Scenario A and 1.425, t = 1.84 in Scenario B), indicating that absolute unexpected earnings induce an incremental rise in classificatory smoothing post-FRS3 for disclosure firms relative to the remaining firms in the sample. In summary, results in Table 911 provide useful insights. They provide evidence of a greater increase in classificatory income smoothing post-FRS3 to reduce deviations of net income from expectations for firms disclosing an alternative EPS in 1996 relative to the remaining firms in the sample in both scenarios. Even though this result outlines the importance of FRS3s option to disclose alternative EPS, evidence on the increase remaining within non-disclosure firms suggests that our core findings are not solely attributable to this option. This might be because firms that did not disclose alternative EPS still smoothed pre-exceptional earnings in the belief that investors would focus on these levels post-FRS3. The structural break for size is consistent with larger firms engaging in a higher level of classificatory smoothing post-FRS3 through all exceptional items. Finally unlike pre-FRS3, post-FRS3 removals of negative non-recurring items by disclosers of alternative EPS yield smoother earnings. 5.3 The effect of FRS3 on earnings persistence We initially examine the extent to which removing CIs increases the persistence of reported earnings in the pre- and post-FRS3 periods and then test whether there is an increase in the persistence of pre-exceptional earnings post-FRS3. Panel A of Table 12 reports the results of earnings persistence regressions for EARN , EARNbXI , EARNbXI&EI pre-FRS3 and EARN , EARNbNOEI , and EARNbEI post-FRS3. The panel reports t-tests for the significance of the differences in the persistence coefficients within each period. Pre-FRS3 the persistence coefficient increases from 0.52 for EARN to 0.59 for EARNbXI . The increase results from the removal of XI and is marginally significant (p = 0.098). Even though the incremental growth in persistence of EARNbXI&EI to 0.64 is not significant, the overall

28

increase in persistence from EARN to EARNbXI&EI pre-FRS3 (0.12) is significant. Post-FRS3, the persistence coefficient increases from 0.49 for EARN to 0.64 for EARNbNOEI and to 0.73 for EARNbEI . The incremental increases of 0.15 and 0.09 are significant, indicating that earnings before NOEI are more persistent than net income and earnings before EI are in turn more persistent than earnings before NOEI. The overall increase in persistence from EARN to EARNbEI post-FRS3 is 0.24, which is double the increase in the pre-FRS3 period. Table 12, Panel B reports the results of estimating equation (2) for four earnings levels: a) EARN , b) EARNADJ1 , c) EARNADJ2 , and d) EARNADJ3. The interaction term captures the change in

persistence of the profit levels post-FRS3. There is no evidence of a significant change in the persistence of EARN post-FRS3. Even though net income is communicated to investors through basic EPS, it appears to be as persistent as in the pre-FRS3 period. The coefficient on FRS 3EARNADJ1 is positive and marginally significant (0.057, t = 1.91), indicating that EARNbNOEI is more persistent than EARNbXI of the pre-FRS3 period. FRS 3EARNADJ2 and FRS 3EARNADJ3 are positive and highly significant

(0.132, t = 5.49 and 0.090, t = 4.15), suggesting that EARNbEI is substantially more persistent than both EARNbXI and EARNbXI&EI pre-FRS3. In sum, results in Table 12 are consistent with our second hypothesis of an increase in the persistence of pre-exceptional profit levels post-FRS3. The results indicate that removing CIs increases the persistence of earnings mainly in the post-FRS3 period. Moreover, excluding all and not just non-operating exceptional items results in more persistent earnings post-FRS3. This evidence is in line with FRS3s provisions enhancing the role of classificatory choices in identifying recurring earnings.
6. Conclusion

We examine the effect of FRS3 on the practice of classificatory income smoothing. Results based on a large balanced sample provide evidence of an overall increase in the practice of classificatory smoothing post-FRS3. The increase coincides with growth in the magnitude of CIs and greater use of income-increasing CIs (e.g. transitory losses, exceptional costs) to smooth pre-exceptional earnings levels. We also find that unlike extraordinary items pre-FRS3, exceptional items post-FRS3 are equally distributed between positive and negative values, indicating that FRS3 succeeded in removing the asymmetry in the

29

distribution of CIs. Results from multivariate analysis further show that deviations of net income from target earnings (lagged adjusted earnings) induce a higher level of classificatory smoothing post-FRS3. Consistent with this evidence, earnings persistence tests show that pre-exceptional earnings levels are significantly more persistent than net income especially post-FRS3. Our results suggest that FRS3

increased the use of classificatory choices to highlight an indicator of sustainable earnings. Our results shed light on managerial smoothing practices following the introduction of FRS3, which have important implications for both investors and accounting standard setters. For investors the main implication is the greater transparency of classificatory smoothing post-FRS3. Investors can identify and assess all adjustments made to basic EPS to arrive at the alternative figure. Even when firms report basic EPS as the sole performance indicator, greater disclosure of exceptionals helps investors extract their preferred measure of persistent profitability. Higher persistence of pre-exceptional earnings post-FRS3 further facilitates investors assessments of firms future prospects. With regard to regulators, FRS3 facilitated communication between managers and the market by enabling classificatory smoothing as a means to convey information about sustainable performance necessary for security valuation. The transparency requirements helped users ascertain whether firms reasonably remove income components, making the practice of classificatory smoothing especially challenging for opportunistic managers. Moreover, by enabling the less costly practice of classificatory smoothing, FRS3 reduced the costs of income smoothing. FRS3 is a reference point for developing a global model for reporting financial performance. In line with FRS3s approach, the IASB, the FASB and the ASB are considering deemphasizing reliance on a single performance indicator (IASB 2005). Our results indicate that FRS3s requirements for a more informative distinction between permanent and transitory income components along with the option to disclose alternative performance measures encouraged the practice of classificatory smoothing. To the extent firms distinguish non-recurring items from permanent income they assist users in evaluating firms future prospects. Evidence on the increased persistence of pre-exceptional earnings appears consistent with this notion. To the extent, however, that managers remove value relevant items from the alternative figure of firm performance to increase the perceived value of the firms ongoing earnings potential (Doyle et al. 2003) then users may be misled and firm valuations become tentative.

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In our analysis we concentrate on the signalling role of smoothing practices. However, despite the increased level of transparency the possibility of opportunistic classificatory choices remains. Although the wide definition of exceptionals in FRS3 allowed for a more precise measure of core profitability, it may have encouraged opportunistic classifications of recurring items. Our research design is not appropriate for capturing classificatory choices motivated by opportunism. This requires a setting where managerial incentives for engaging in income-increasing earnings management are particularly strong. Empirical evidence suggests that meeting or exceeding earnings benchmarks is a strong asset pricing motivation for inflating reported earnings (Burgstahler and Dichev 1997, Degeorge, Patel and Zeckhauser 1999, Bartov, Givoly and Hayn 2002). To the extent UK firms simultaneously increase and smooth alternative earnings through classification items, especially post-FRS3, they may move items below the line of alternative EPS in an attempt to inflate earnings and meet or beat analyst forecasts. The latter benchmark provides strong incentives for income-increasing earnings management, offering a suitable context for identifying opportunistic classifications.

References

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34

Appendix

Smoothing objects and related dimensions

Income statement items Sales less Cost of sales Gross Margin less Operating discretionary expenses Operating Income less less less Depreciation Discretionary fixed charges Other charges Ordinary income less Non-recurring and non-operating items Net income

Smoothing dimensions

Inter-temporal Classificatory

Adapted from Figure 3.2 of Ronen and Sadan (1981, p.44) on the relation between smoothing objects and smoothing dimensions. When the smoothing object is operating or ordinary income, managers can smooth either inter-temporally from above or from below through classificatory items (e.g. classifications of depreciation, discretionary fixed charges and other charges, and non-recurring and non-operating items). Firms smooth net income only inter-temporally through all items above it.

35

Table 1 Measures of the overall magnitude of classificatory income smoothing Classificatory smoothing index (CSI ) Smoothing index (SI ) Period Level of earnings EARN SI 1 = Pre-FRS3 EARN REV EARNbXI CSI = SI 1 min( SI 1 , SI 2 ) SI 2 = EARNbXI REV EARN SI 1 = Post-FRS3 EARN REV Scenario A: EARNbNOEI SI 3 = EARNbNOEI CSI = SI 1 min( SI 1 , S 3 , S 4 ) REV Scenario B: EARNbEI SI 4 = EARNbEI CSI = SI 1 min( SI 1 , S 3 ) REV
EARN is earnings after extraordinary items. EARNbXI is earnings before extraordinary items. EARNbNOEI is earnings before nonoperating exceptional items. EARNbEI is earnings before all exceptional items.

36

Table 2 Panel A: Descriptive statistics for XI and EI pre-FRS3, NOEI and OEI post-FRS3. Std. dev. N Variable Mean Period
Pre-FRS3 5,677
XI (a) EI (b)

Median 0.000 0.000 0.000 0.000 0.000 0.000

0.004*** 0.003*** 0.007*** 0.007*** 0.006*** 0.013*** 0.003 (<0.001) 0.003 (<0.001)

0.036 0.030 0.049 0.044 0.031 0.060

Post-FRS3

4,969

Total NOEI (c)

OEI (d) Total

Diff (c)(a) (p-value) Diff (d)(b) (p-value)

Panel B: Descriptive statistics by year for XI and EI pre-FRS3, NOEI and OEI post-FRS3. Std. dev. N Variable Mean Median Year
1986 1987 1988 1989 1990 1991 1992&1993 (pre)a 1992&1993 (post)b 608 668 754 818 890 942 997
XI EI XI EI XI EI XI EI XI EI XI EI XI EI

0.004*** 0.001 0.002 0.001 0.001 0.002** 0.002 0.002*** 0.005*** 0.002** 0.008*** 0.007*** 0.011*** 0.010*** 0.010*** 0.005*** 0.006*** 0.004*** 0.007*** 0.006*** 0.006*** 0.005*** 0.003** 0.006*** 0.011*** 0.011***

0.033 0.018 0.036 0.023 0.034 0.019 0.039 0.016 0.037 0.033 0.033 0.037 0.037 0.042 0.047 0.032 0.043 0.025 0.041 0.030 0.044 0.032 0.038 0.032 0.051 0.038

0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

941

XI NOEI OEI

1994 1995 1996 1997 1998

955 928 881 812 452

NOEI OEI NOEI OEI NOEI OEI NOEI OEI NOEI OEI

37

Panel C: Frequencies of positive, negative, and zero XI and EI pre-FRS3, NOEI and OEI post-FRS3. Pre-FRS3 Post-FRS3
Variable
XI > 0 XI < 0 XI = 0 EI > 0 EI < 0 EI = 0 N

Freq (%)c 15.04 30.46 54.50 46.54 34.47 18.99 5,677

Freq (%)d 33.06 66.94

p-value

Variable
NOEI > 0 NOEI < 0 NOEI = 0

Freq (%)c 23.78 23.65 52.57 40.57 41.96 17.47 4,969

Freq (%)d 50.15 49.85

p-value

<0.001

0.805

57.45 42.55

<0.001

OEI > 0 OEI < 0 OEI = 0

49.16 50.84

0.332

Panel D: Annual frequencies of positive, negative, and zero XI and EI pre-FRS3, NOEI and OEI post-FRS3.
By year 1986 1987 1988 1989 1990 1991 1992&1993 (pre)a By year 1992&1993 (post)b 1994 1995 1996 1997 1998
XI > 0 XI < 0 XI = 0 p-value EI > 0 EI < 0 EI = 0 p-value

14.64% 20.51% 19.76% 23.23% 16.18% 9.87% 5.22%

35.53% 30.24% 25.33% 26.65% 35.17% 34.18% 26.78%

49.84% 49.25% 54.91% 50.12% 48.65% 55.94% 68.00%

<0.001 <0.001 0.026 0.181 <0.001 <0.001 <0.001

48.52% 47.01% 50.53% 50.49% 47.08% 44.27% 40.42%

28.95% 30.54% 25.86% 27.63% 34.94% 42.04% 45.04%

22.53% 22.46% 23.61% 21.88% 17.98% 13.69% 14.54%

<0.001 <0.001 <0.001 <0.001 <0.001 0.483 0.160

NOEI > 0

NOEI < 0

NOEI = 0

p-value

OEI > 0

OEI < 0

OEI = 0

p-value

22.32% 23.98% 22.95% 24.52% 25.74% 23.01%

28.69% 21.17% 21.88% 23.95% 20.69% 23.01%

48.99% 54.85% 55.17% 51.53% 53.57% 23.01%

0.007 0.178 0.590 0.772 0.030 0.286

42.19% 42.75% 42.13% 40.98% 35.59% 37.17%

39.21% 39.94% 39.87% 40.41% 46.55% 50.66%

18.60% 17.31% 18.00% 18.62% 17.86% 12.17%

0.329 0.356 0.425 0.823 <0.001 0.003

*/**/*** significant at 0.1/0.05/0.01 levels (two-tailed). p-value corresponds to a binomial test (two sided) for the difference of frequencies of positive and negative non-recurring items conditional on non-zero disclosures. The sample consists of 10,646 firmyear observations over the period 19861998 (pre-FRS10) for 993 UK non-financial firms with at least one observation in both the pre and post-FRS3 periods. a Includes pre-FRS3 observations of 1992 and 1993 b Includes post-FRS3 observations of 1992 and 1993 c Over total number of observations d Over total number of non-zero observations XI is total extraordinary items. EI is total exceptional items. NOEI is non-operating exceptional items. OEI is operating exceptional items (total exceptional items minus non-operating exceptional items). All variables are scaled by lagged total assets.

38

Table 3 The overall magnitude of classificatory income smoothing (classificatory smoothing indexCSI)
Pre-FRS3 Post-FRS3 Scenario A: Mean/ SO = (EARN, EARNbNOEI, (Median) EARNbEI) 0.063*** CSI = SI1 min(SI1, SI3, SI4 ) (0.004)*** 914 C: 387 UC: 527 Scenario B: Mean/ SO = (EARN, (Median) EARNbNOEI) 0.157*** (0.023)*** 914 C: 199 UC: 715 0.094 (0.019) <0.001 (<0.001)

SO = (EARNbXI)

Mean/ (Median) 0.102*** (0.006)*** 914 C: 364 UC: 550 0.039 (0.002) 0.033 (0.261)

CSI = SI1 min( SI1, SI 2 )

CSI = SI1 min(SI1, SI3 )

Diff. (pre post).

p-valuea

*** significant at 1% (two-tailed) using a t-test for the means and distribution free confidence intervals for the medians. a p-value corresponds to a Wilcoxon non-parametric test (two-sided) for the difference in means and medians between the pre- and postFRS3 period. The sample consists of 914 UK non-financial firms with at least two observations in both the pre and post-FRS3 periods. Table 1 defines the smoothing indices (SI). Standard deviations are calculated at the firm level for each period. SO is the smoothing object. EARN is earnings after extraordinary items. EARNbXI is earnings before extraordinary items. EARNbNOEI is earnings before nonoperating exceptional items. EARNbEI is earnings before all exceptional items. Pre-FRS3, CSI measures income smoothing from classifications of extraordinary items. Post-FRS3 in Scenario A, CSI measures income smoothing from classifications of either nonoperating or all exceptional items in line with the smoothing object. In Scenario B, CSI measures income smoothing from classifications of non-operating exceptional items. C is the number of censored observations (CSI0). UC is the number of uncensored observations (CSI>0).

39

Table 4 Descriptive statistics on key variables affecting the variation of the classificatory smoothing index (CSI) Variable
DIVERGENCE (Scenario A) DIVERGENCE

Statistics Mean Std. dev. Median Mean Std. dev. Median Mean Std. dev. Median Mean Std. dev. Median Mean Std. dev. Median Mean Std. dev. Median Mean Std. dev. Median Mean Std. dev. Median

Pre-FRS3 (N=914) 0.070*** 0.155 0.026 0.070*** 0.155 0.026 0.032*** 0.086 0.000 0.032*** 0.086 0.000 0.138*** 0.228 0.000 0.138*** 0.228 0.000 0.824*** 0.370 0.849 0.179*** 0.131 0.163 4.352*** 2.755 4.143 4.540*** 1.344 4.613 4.531*** 1.344 4.613 0.004*** 0.017 0.000 0.004*** 0.017 0.000

Post-FRS3 (N=914) 0.057*** 0.125 0.024 0.058*** 0.127 0.025 0.053*** 0.113 0.000 0.037*** 0.090 0.000 0.131*** 0.250 0.000 0.145*** 0.247 0.000 0.753*** 0.452 0.770 0.185*** 0.155 0.163 4.463*** 2.249 4.333 4.463*** 2.249 4.333 4.507*** 1.448 4.667 0.012*** 0.030 0.000 0.007*** 0.021 0.000

p-valuea

0.012 0.064 0.057 0.161 <0.001 0.001 0.458 0.949 0.015 0.001 0.819 0.380 <0.001 0.003 0.999 0.870 0.356 0.322 0.415 0.295 0.794 0.597 <0.001 <0.001 0.310 0.757

(Scenario B)
GAINLOSS

(Scenario A)
GAINLOSS

(Scenario B)
PERMLOSS (Scenario A) PERMLOSS

(Scenario B)
RISK()

Leverage (LEV)

SIZE

Mean Std. dev. Median Mean Std. dev. Median

Profitability Index (PI)

Change in Profitability Index (PI)

Mean Std. dev. Median Mean Std. dev. Median Mean Std. dev. Median

Level impact of classification items (LI) (Scenario A) Level impact of classification items (LI) (Scenario B)

*** significant at 1% (two-tailed) using a t-test for the means and distribution free confidence intervals for the medians. a p-value corresponds to a Wilcoxon non-parametric test (two-sided) for the difference in means and medians between the pre- and postFRS3 period. The sample consists of 914 UK non-financial firms with at least two observations in both the pre and post-FRS3 periods. We calculate all variables annually and use the pre- and post-FRS3 averages. DIVERGENCE is the absolute value of the difference between pre-managed earnings (net income) and expected earnings scaled by total sales. Expected earnings is lagged ordinary income preFRS3, and lagged earnings before non-operating exceptional items (Scenario B) or further earnings before all exceptional items (Scenario A) post-FRS3. GAINLOSS equals 1if net income is negative and the smoothing object is positive, 0 otherwise. The smoothing object is ordinary income pre-FRS3 and earnings before non-operating exceptional items (Scenario B) or further earnings before all exceptional items (Scenario A). PERMLOSS equals 1 if the smoothing object is negative, 0 otherwise. RISK() is the beta coefficient derived from firm specific regressions of stock return on the FTSE All Share Index return over a 60 month window ending at the financial year end in question. LEV is total book value of debt over total assets. SIZE is the decile formed each year by sorting observations into 10 groups based on lagged market value of equity (0 is the lowest, 9 the highest decile). PI is the decile formed each year by sorting observations into 10 groups based on net income scaled by lagged total assets. PI is the decile formed each year by sorting observations into 10 groups based on the annual change in net income scaled by lagged total assets. LI equals the income-increasing (decreasing) effect of negative (positive) extraordinary items ( LI = XI ) pre-FRS3, and non-operating exceptional items ( LI = NOEI ), Scenario B) or further all exceptional items ( LI = NOEI or EI, Scenario A) post-FRS3. LI is zero when CSI is zero and is scaled by lagged total assets.

40

Table 5 Regressions of the classificatory smoothing index (CSI) on an FRS3 indicator, divergence from expected earnings, and a set of control variables.
Scenario A Model 1 Variables Intercept
FRS3 DIVERGENCE FRS3 DIVERGENCE GAINLOSS PERMLOSS RISK() LEV SIZE PI

Scenario B Model 2 Coefficient (t-statistic) 0.058 (1.48) 0.015 (1.17) 0.264** (2.43) 0.373** (2.15) 0.413*** (4.09) 0.079* (1.70) 0.027* (1.65) 0.246*** (3.69) 0.012*** (4.26) 0.008* (1.85) 0.019*** (3.01) 3.397*** (5.59) 1,828 (C:751/UC:1077) 534.10 <0.001 Partial Effects

Predicted Sign

+ + + + + + +

PI
LI

Coefficient (t-statistic) 0.060 (1.45) 0.072*** (4.68) 0.278** (2.41) 0.702*** (2.88) 0.320*** (3.13) 0.103* (1.82) 0.030* (1.66) 0.236*** (3.11) 0.014*** (4.54) 0.010** (2.32) 0.020*** (2.80) 3.863*** (6.04) 1,828 (C:586 /UC:1242) 788.66 <0.001

Partial effects

0.040 0.155 0.390 0.178 0.057 0.017 0.131 0.008 0.004 0.011 2.146

0.007 0.130 0.184 0.203 0.039 0.013 0.121 0.006 0.004 0.010 1.672

Chi-square p-value

*/**/*** significant at 0.1/0.05/0.01 levels (two-tailed). t-statistics in parentheses are calculated on White standard errors. The coefficients are estimated using a corner solution Tobit model. C is the number of censored observations. UC is the number of uncensored observations. The sample consists of 914 UK non-financial firms with at least two observations in both the pre and post-FRS3 periods. CSI measures income smoothing from classifications of extraordinary items pre-FRS3, and non-operating exceptional items (Scenario B) or further all exceptional items (Scenario A) post-FRS3 in line with the smoothing object (see Table 1). FRS3 equals 1 if the observation belongs to the post-FRS3 period, 0 if it belongs to the pre-FRS3 period. We calculate all explanatory variables annually and use the pre- and post-FRS3 averages. DIVERGENCE is the absolute value of the difference between pre-managed earnings (net income) and expected earnings scaled by total sales. Expected earnings is lagged ordinary income pre-FRS3, and lagged earnings before non-operating exceptional items (Scenario B) or further earnings before all exceptional items (Scenario A) post-FRS3. GAINLOSS equals 1if net income is negative and the smoothing object is positive, 0 otherwise. The smoothing object is ordinary income pre-FRS3 and earnings before non-operating exceptional items (Scenario B) or further earnings before all exceptional items (Scenario A). PERMLOSS equals 1 if the smoothing object is negative, 0 otherwise. RISK() is the beta coefficient derived from firm specific regressions of stock return on the FTSE All Share Index return over a 60 month window ending at the financial year end in question. LEV is total book value of debt over total assets. SIZE is the decile formed each year by sorting observations into 10 groups based on lagged market value of equity (0 is the lowest, 9 the highest decile). PI is the decile formed each year by sorting observations into 10 groups based on net income scaled by lagged total assets. PI is the decile formed each year by sorting observations into 10 groups based on the annual change in net income scaled by lagged total assets. LI equals the income-increasing (decreasing) effect of negative (positive) extraordinary items ( LI = XI ) pre-FRS3, and non-operating exceptional items ( LI = NOEI ), Scenario B) or further all exceptional items ( LI = NOEI or EI, Scenario A) post-FRS3. LI is zero when CSI is zero and is scaled by lagged total assets.

41

Table 6 Regressions of the classificatory smoothing index (CSI) on an FRS3 indicator, divergence from expected earnings and a set of control variables for firms with at least five observations in each of the pre and post-FRS3 periods.
Scenario A Model 1 Variables Intercept
FRS3 DIVERGENCE FRS3 DIVERGENCE GAINLOSS PERMLOSS RISK() LEV SIZE PI

Scenario B Model 2 Coefficient (t-statistic) 0.037 (0.87) 0.011 (0.70) 0.286* (1.80) 0.754** (2.41) 0.540*** (4.70) 0.002 (0.04) 0.015 (0.74) 0.177** (2.15) 0.014*** (4.40) 0.008* (1.79) 0.015** (2.10) 2.652*** (3.75) 1,218 (C:446/UC:772) 386.98 <0.001 Partial effects

Predicted Sign

+ + + + + + +

PI
LI

Coefficient (t-statistic) 0.055 (1.19) 0.041** (2.25) 0.340* (1.93) 1.410*** (3.24) 0.450*** (3.81) 0.006 (0.09) 0.022 (0.93) 0.086 (0.84) 0.016*** (4.52) 0.013*** (2.75) 0.006 (0.75) 3.798*** (4.70) 1,218 (C:348/UC:870) 585.08 <0.001

Partial effects

0.024 0.198 0.820 0.262 0.004 0.013 0.050 0.009 0.008 0.003 2.208

0.006 0.150 0.396 0.283 0.001 0.008 0.093 0.007 0.004 0.008 1.391

Chi-square p-value

*/**/*** significant at 0.1/0.05/0.01 levels (two-tailed). t-statistics in parentheses are calculated on White standard errors. The coefficients are estimated using a corner solution Tobit model. C is the number of censored observations. UC is the number of uncensored observations. The sample consists of 609 UK non-financial firms with at least five observations in each of he pre and post-FRS3 periods. CSI measures income smoothing from classifications of extraordinary items pre-FRS3, and non-operating exceptional items (Scenario B) or further all exceptional items (Scenario A) post-FRS3 in line with the smoothing object (see Table 1). FRS3 equals 1 if the observation belongs to the post-FRS3 period, 0 if it belongs to the pre-FRS3 period. We calculate all explanatory variables annually and use the pre- and post-FRS3 averages. DIVERGENCE is the absolute value of the difference between pre-managed earnings (net income) and expected earnings scaled by total sales. Expected earnings is lagged ordinary income pre-FRS3, and lagged earnings before non-operating exceptional items (Scenario B) or further earnings before all exceptional items (Scenario A) post-FRS3. GAINLOSS equals 1if net income is negative and the smoothing object is positive, 0 otherwise. The smoothing object is ordinary income pre-FRS3 and earnings before non-operating exceptional items (Scenario B) or further earnings before all exceptional items (Scenario A). PERMLOSS equals 1 if the smoothing object is negative, 0 otherwise. RISK() is the beta coefficient derived from firm specific regressions of stock return on the FTSE All Share Index return over a 60 month window ending at the financial year end in question. LEV is total book value of debt over total assets. SIZE is the decile formed each year by sorting observations into 10 groups based on lagged market value of equity (0 is the lowest, 9 the highest decile). PI is the decile formed each year by sorting observations into 10 groups based on net income scaled by lagged total assets. PI is the decile formed each year by sorting observations into 10 groups based on the annual change in net income scaled by lagged total assets. LI equals the income-increasing (decreasing) effect of negative (positive) extraordinary items ( LI = XI ) pre-FRS3, and non-operating exceptional items ( LI = NOEI ), Scenario B) or further all exceptional items ( LI = NOEI or EI, Scenario A) post-FRS3. LI is zero when CSI is zero and is scaled by lagged total assets.

42

Table 7 Regressions of the classificatory smoothing index (CSI) on an FRS3 indicator, divergence from expected earnings, a set of control variables and interaction terms.
Predicted Sign Scenario A Model 1 Coefficient Coefficient (t-statistic) (t-statistic) 0.078 (1.41) 0.092 0.050 (1.15) 0.280** 0.083 (2.39) 0.667** 0.224 (2.46) 0.398*** 0.225 (3.02) 0.125* 0.057 (1.70) 0.043 0.024 (1.32) 0.341*** 0.194 (3.12) 0.009** 0.005 (2.53) 0.010 0.006 (1.57) 0.016* 0.008 (1.79) 2.056** 1.225 (2.39) 0.114 0.043 (0.60) 0.039 0.054 (0.36) 0.021 0.015 (0.51) 0.165 0.078 (1.09) 0.008 0.004 (1.30) 0.000 0.002 (0.00) 0.005 0.005 (0.37) 2.459** 1.370 (2.03) 1,828 (C:586/UC:1242) 806.63 <0.001 Scenario B Model 2 Coefficient (t-statistic) 0.068 (1.27) 0.024 (0.32) 0.279** (2.45) 0.329* (1.70) 0.378*** (2.96) 0.115 (1.63) 0.036 (1.16) 0.338*** (3.17) 0.008*** (2.56) 0.008 (1.39) 0.016* (1.84) 1.997** (2.26) 0.060 (0.32) 0.058 (0.62) 0.015 (0.40) 0.147 (1.06) 0.005 (0.85) 0.002 (0.29) 0.005 (0.38) 2.371* (1.92) 1,828 (C:751/UC:1077) 554.19 <0.001 Partial effects

Variables Intercept
FRS3 DIVERGENCE FRS3 DIVERGENCE GAINLOSS PERMLOSS RISK() LEV SIZE PI

0.012 0.138 0.162 0.186 0.057 0.018 0.167 0.004 0.004 0.008 0.986 0.030 0.029 0.008 0.073 0.002 0.001 0.003 1.170

+ + + + + + +

PI
LI FRS3 GAINLOSS FRS3 PERMLOSS FRS3 RISK FRS3 LEV FRS3 SIZE FRS3 PI FRS3 PI FRS3 LI N

Chi-square p-value

*/**/*** significant at 0.1/0.05/0.01 levels (two-tailed). t-statistics in parentheses are calculated on White standard errors. The coefficients are estimated using a corner solution Tobit model. The dependent variable is left censored at zero. C is the number of censored observations. UC is the number of uncensored observations. The sample consists of 914 UK non-financial firms with at least two observations in both the pre and post-FRS3 periods. CSI measures income smoothing from classifications of extraordinary items pre-FRS3, and non-operating exceptional items (Scenario B) or further all exceptional items (Scenario B) post-FRS3 in line with the smoothing object (see Table 1). FRS3 equals 1 if the observation belongs to the post-FRS3 period, 0 if it belongs to the pre-FRS3 period. We calculate all explanatory variables annually and use the pre- and post-FRS3 averages. DIVERGENCE is the absolute value of the difference between pre-managed earnings (net income) and expected earnings scaled by total sales. Expected earnings is lagged ordinary income pre-FRS3, and lagged earnings before non-operating exceptional items (Scenario B) or further earnings before all exceptional items (Scenario A) post-FRS3. GAINLOSS equals 1if net income is negative and the smoothing object is positive, 0 otherwise. The smoothing object is ordinary income pre-FRS3 and earnings before non-operating exceptional items (Scenario B) or further earnings before all exceptional items (Scenario A). PERMLOSS equals 1 if the smoothing object is negative, 0 otherwise. RISK() is the beta coefficient derived from firm specific regressions of stock return on the FTSE All Share Index return over a 60 month window ending at the financial year end in question. LEV is total book value of debt over total assets. SIZE is the decile formed each year by sorting observations into 10 groups based on lagged market value of equity (0 is the lowest, 9 the highest decile). PI is the decile formed each year by sorting observations into 10 groups based on net income scaled by lagged total assets. PI is the decile formed each year by sorting observations into 10 groups based on the annual change in net income scaled by lagged total assets. LI equals the income-increasing (decreasing) effect of negative (positive) extraordinary items ( LI = XI ) pre-FRS3, and non-

43

operating exceptional items ( LI = NOEI ), Scenario B) or further all exceptional items ( LI = NOEI or EI, Scenario A) post-FRS3. LI is zero when CSI is zero and is scaled by lagged total assets.

44

Table 8 The magnitude of classificatory income smoothing (Classificatory smoothing indexCSI) for firms disclosing alternative EPS in 1996. Post-FRS3 Pre-FRS3
SO=(EARNbXI)
CSI = SI1 min(SI1, SI 2 )

Mean/ (Median) 0.071*** (0.016)*** 197 C: 58 UC: 139

Scenario A: SO=(EARN, EARNbNOEI, EARNbEI)

CSI = SI1 min( S1 , S3 , S 4 )

Mean/ (Median)

Scenario B: Mean/ SO=(EARN, EARNbNOEI) (Median) 0.127*** (0.026)*** 197 C: 51 UC: 146 0.075 (0.010) 0.019 (0.365)

0.190*** (0.068)*** CSI = SI1 min(S1 , S3 ) 197 C: 33 UC: 164 0.119 (0.052) <0.001 (<0.001)

Diff (pre post).

p-valuea

*** significant at 1% (two-tailed) using a t-test for the means and distribution free confidence intervals for the medians. a p-value corresponds to a Wilcoxon non-parametric test (two-sided) for the difference in means and medians between the pre- and post-FRS3 period. The sample consists of 197 non-financial firms included in the 500 largest UK firms disclosing alternative EPS in 1996. Of the total number of alternative EPS disclosers included in the largest 500 UK firms (254 firms) we exclude 57 firms that do not satisfy our sample criteria. Retained firms have at least two observations in both the pre- and post-FRS3 periods. Table 1 defines the smoothing indices (SI). Standard deviations are calculated at the firm level for each period. SO is the smoothing object. EARN is earnings after extraordinary items. EARNbXI is earnings before extraordinary items. EARNbNOEI is earnings before non-operating exceptional items. EARNbEI is earnings before all exceptional items. Pre-FRS3, CSI measures income smoothing from classifications of extraordinary items. Post-FRS3 in Scenario A, CSI measures income smoothing from classifications of either non-operating or all exceptional items in line with the smoothing object. In Scenario B, CSI measures income smoothing resulting from classifications of non-operating exceptional items.

45

Table 9 Regressions of the classificatory smoothing index (CSI) on an FRS3 indicator, divergence from expected earnings and a set of control variables for firms disclosing alternative EPS in 1996.
Scenario A Model 1 Variables Intercept
FRS3 DIVERGENCE FRS3 DIVERGENCE GAINLOSS PERMLOSS RISK() LEV SIZE PI

Scenario B Model 2 Coefficient (t-statistic) 0.139 (1.34) 0.035 (1.21) 0.516** (2.14) 2.122** (2.52) 0.723*** (3.63) 0.147 (0.85) 0.057 (1.44) 0.140 (1.18) 0.021*** (2.79) 0.005 (0.68) 0.018 (1.47) 0.622 (0.47) 394 (C:109/UC:285) 131.17 <0.001 Partial effects

Predicted Sign

+
+

+ + + + +

PI
LI

Coefficient (t-statistic) 0.139 (0.99) 0.047* (1.90) 0.590** (1.99) 4.274*** (5.74) 0.306* (1.81) 0.095 (0.40) 0.053 (1.20) 0.094 (0.74) 0.029*** (3.37) 0.011 (1.52) 0.021 (1.60) 2.609* (1.86) 394 (C:91/UC:303) 199.77 <0.001

Partial Effects

0.031 0.388 2.808 0.201 0.062 0.035 0.062 0.019 0.007 0.014 1.714

0.021 0.313 1.288 0.438 0.089 0.034 0.085 0.012 0.003 0.011 0.378

Chi-square p-value

*/**/*** significant at 0.1/0.05/0.01 levels (two-tailed). T-statistics in parentheses are calculated on White standard errors. The coefficients are estimated using a corner solution Tobit model. C is the number of censored observations. UC is the number of uncensored observations. The sample consists of 197 non-financial firms included in the 500 largest UK firms that disclosed alternative EPS in 1993/1994. Of the total number of alternative EPS disclosers included in the largest 500 UK firms (254 firms) we exclude 57 firms that do not satisfy our sample criteria. Retained firms have at least two observations in both the pre- and post-FRS3 periods. CSI measures income smoothing from classifications of extraordinary items pre-FRS3, and non-operating exceptional items (Scenario B) or further all exceptional items (Scenario A) post-FRS3 in line with the smoothing object (see Table 1). FRS3 equals 1 if the observation belongs to the post-FRS3 period, 0 if it belongs to the pre-FRS3 period. We calculate all explanatory variables annually and use the pre- and post-FRS3 averages. DIVERGENCE is the absolute value of the difference between pre-managed earnings (net income) and expected earnings scaled by total sales. Expected earnings is lagged ordinary income pre-FRS3, and lagged earnings before non-operating exceptional items (Scenario B) or further earnings before all exceptional items (Scenario A) post-FRS3. GAINLOSS equals 1if net income is negative and the smoothing object is positive, 0 otherwise. The smoothing object is ordinary income pre-FRS3 and earnings before non-operating exceptional items (Scenario B) or further earnings before all exceptional items (Scenario A). PERMLOSS equals 1 if the smoothing object is negative, 0 otherwise. RISK() is the beta coefficient derived from firm specific regressions of stock return on the FTSE All Share Index return over a 60 month window ending at the financial year end in question. LEV is total book value of debt over total assets. SIZE is the decile formed each year by sorting observations into 10 groups based on lagged market value of equity (0 is the lowest, 9 the highest decile). PI is the decile formed each year by sorting observations into 10 groups based on net income scaled by lagged total assets. PI is the decile formed each year by sorting observations into 10 groups based on the annual change in net income scaled by lagged total assets. LI equals the income-increasing (decreasing) effect of negative (positive) extraordinary items ( LI = XI ) pre-FRS3, and non-operating exceptional items ( LI = NOEI ), Scenario B) or further all exceptional items ( LI = NOEI or EI, Scenario A) post-FRS3. LI is zero when CSI is zero and is scaled by lagged total assets.

46

Table 10 Regressions of the classificatory smoothing index (CSI) on an FRS3 indicator, divergence from expected earnings, a set of control variables and interaction terms for firms disclosing alternative EPS in 1996.
Scenario A Model 1 Variables Intercept
FRS3 DIVERGENCE FRS3 DIVERGENCE GAINLOSS PERMLOSS RISK() LEV SIZE PI

Scenario B Model 2 Coefficient (t-statistic) 0.085 (0.83) 0.478** (2.13) 0.385* (1.71) 2.195** (2.41) 0.453** (2.02) 0.244* (1.84) 0.052 (1.03) 0.055 (0.29) 0.008 (1.23) 0.015* (1.76) 0.025* (1.86) 2.661** (2.22) 0.291 (0.90) 0.315 (0.98) 0.013 (0.17) 0.166 (0.65) 0.008 (1.23) 0.022 (1.49) 0.018 (0.73) 6.147*** (2.39) 394 (C:109/UC:285) 155.57 <0.001 Coefficient (t-statistic)

Predicted Sign

+ + + + + + +

PI
LI FRS3 GAINLOSS FRS3 PERMLOSS FRS3 RISK FRS3 LEV FRS3 SIZE FRS3 PI FRS3 PI FRS3 LI N

Chi-square p-value

Coefficient (t-statistic) 0.082 (0.77) 0.482** (2.00) 0.389* (1.73) 4.115*** (6.70) 0.463** (2.03) 0.251* (1.84) 0.058 (1.09) 0.048 (0.24) 0.008 (1.17) 0.016* (1.80) 0.025* (1.81) 2.677** (2.20) 0.312 (0.93) 0.591 (1.09) 0.004 (0.05) 0.129 (0.48) 0.033* (1.81) 0.018 (1.31) 0.010 (0.40) 8.476*** (3.66) 394 (C:91/UC:303) 239.40 <0.001

Partial effects

0.309 0.261 2.761 0.312 0.168 0.037 0.032 0.005 0.011 0.017 1.796 0.210 0.397 0.002 0.087 0.022 0.012 0.007 5.689

0.285 0.237 1.352 0.279 0.150 0.032 0.034 0.005 0.011 0.016 1.639 0.179 0.194 0.008 0.102 0.013 0.013 0.011 3.787

*/**/*** significant at 0.1/0.05/0.01 levels (two-tailed). T-statistics in parentheses are calculated on White standard errors. The coefficients are estimated using a corner solution Tobit model. The dependent variable is left censored at zero. C is the number of censored observations. UC is the number of uncensored observations. The sample consists of 197 non-financial firms included in the 500 largest UK firms that disclosed alternative EPS in 1996. Of the total number of alternative EPS disclosers included in the largest 500 UK firms (254 firms) we exclude 57 firms that do not satisfy our sample criteria. Retained firms have at least two observations in both the pre- and post-FRS3 periods. CSI measures income smoothing from classifications of extraordinary items pre-FRS3, and non-operating exceptional items (Scenario B) or further all exceptional items (Scenario A) post-FRS3 in line with the smoothing object (see Table 1). FRS3 equals 1 if the observation belongs to the post-FRS3 period, 0 if it belongs to the pre-FRS3 period. We calculate all explanatory variables annually and use the pre- and post-FRS3 averages. DIVERGENCE is the absolute value of the difference between pre-managed earnings (net income) and expected earnings scaled by total sales. Expected earnings is lagged ordinary income pre-FRS3, and lagged earnings before non-operating exceptional items (Scenario B) or further earnings before all exceptional items (Scenario A) post-FRS3. GAINLOSS equals 1if net income is negative and the smoothing object is positive, 0 otherwise. The smoothing object is ordinary income pre-FRS3 and earnings before non-operating exceptional items (Scenario B) or further earnings before all exceptional items (Scenario A). PERMLOSS equals 1 if the smoothing object is negative, 0 otherwise. RISK() is the beta coefficient derived from firm specific regressions of stock return on the FTSE All Share Index return over a 60 month window ending at the financial year end in question. LEV is total book value of debt over total assets. SIZE is the decile formed each year by sorting observations into 10 groups based on lagged market value of equity (0 is the lowest, 9 the highest decile). PI is the

47

decile formed each year by sorting observations into 10 groups based on net income scaled by lagged total assets. PI is the decile formed each year by sorting observations into 10 groups based on the annual change in net income scaled by lagged total assets. LI equals the income-increasing (decreasing) effect of negative (positive) extraordinary items ( LI = XI ) pre-FRS3, and non-operating exceptional items ( LI = NOEI ), Scenario B) or further all exceptional items ( LI = NOEI or EI, Scenario A) post-FRS3. LI is zero when CSI is zero and is scaled by lagged total assets.

48

Table 11 Regressions of the classificatory smoothing index (CSI) on an FRS3 indicator, divergence from expected earnings, and a set of control variables firms disclosing alternative EPS in 1996 versus remaining firms in the balanced sample.
Scenario A Model 1 Variables Intercept
FRS3 DIS DIVERGENCE FRS3 DIVERGENCE DIS DIVERGENCE DIS FRS3 DIVERGENCE GAINLOSS PERMLOSS RISK() LEV SIZE PI

Scenario B Model 2 Coefficient (t-statistic) 0.042 (1.08) 0.002 (0.16) 0.005* (0.25) 0.220* (1.88) 0.393** (2.26) 0.384 (1.31) 1.425* (1.84) 0.376*** (3.79) 0.083* (1.81) 0.027* (1.65) 0.239*** (3.57) 0.008** (2.52) 0.008** (2.00) 0.018*** (2.75) 3.543*** (5.86) 1,828 (C:751/UC:1077) 563.38 <0.001 Partial Effects

Predicted Sign

+ + + + + + + + +

PI
LI

Coefficient (t-statistic) 0.040 (0.99) 0.048*** (3.34) 0.035* (1.77) 0.213* (1.74) 0.730*** (3.27) 0.537 (1.54) 2.404*** (3.60) 0.283*** (2.79) 0.107* (1.95) 0.028* (1.66) 0.229*** (3.02) 0.012*** (3.33) 0.011*** (2.60) 0.017** (2.42) 3.942*** (6.20) 1,828 (C:586 /UC:1242) 841.60 <0.001

Partial effects

0.027 0.019 0.119 0.408 0.300 1.346 0.159 0.060 0.016 0.128 0.006 0.006 0.010 2.206

0.001 0.002 0.109 0.194 0.189 0.703 0.185 0.041 0.013 0.118 0.004 0.004 0.009 1.748

Chi-square p-value

*/**/*** significant at 0.1/0.05/0.01 levels (two-tailed). t-statistics in parentheses are calculated on White standard errors. The coefficients are estimated using a corner solution Tobit model. C is the number of censored observations. UC is the number of uncensored observations. The sample consists of 914 UK non-financial firms with at least two observations in both the pre and post-FRS3 periods. CSI measures income smoothing from classifications of extraordinary items pre-FRS3, and non-operating exceptional items (Scenario B) or further all exceptional items (Scenario A) post-FRS3 in line with the smoothing object (see Table 1). FRS3 equals 1 if the observation belongs to the postFRS3 period, 0 if it belongs to the pre-FRS3 period. DIS equals 1 if a firm (among the largest 500 UK firms) discloses alternative EPS in 1996, 0 otherwise. We calculate all explanatory variables annually and use the pre- and post-FRS3 averages. DIVERGENCE is the absolute value of the difference between pre-managed earnings (net income) and expected earnings scaled by total sales. Expected earnings is lagged ordinary income preFRS3, and lagged earnings before non-operating exceptional items (Scenario B) or further earnings before all exceptional items (Scenario A) postFRS3. GAINLOSS equals 1if net income is negative and the smoothing object is positive, 0 otherwise. The smoothing object is ordinary income preFRS3 and earnings before non-operating exceptional items (Scenario B) or further earnings before all exceptional items (Scenario A). PERMLOSS equals 1 if the smoothing object is negative, 0 otherwise. RISK() is the beta coefficient derived from firm specific regressions of stock return on the FTSE All Share Index return over a 60 month window ending at the financial year end in question. LEV is total book value of debt over total assets. SIZE is the decile formed each year by sorting observations into 10 groups based on lagged market value of equity (0 is the lowest, 9 the highest decile). PI is the decile formed each year by sorting observations into 10 groups based on net income scaled by lagged total assets. PI is the decile formed each year by sorting observations into 10 groups based on the annual change in net income scaled by lagged total assets. LI equals the income-increasing (decreasing) effect of negative (positive) extraordinary items ( LI = XI ) pre-FRS3, and non-operating exceptional items ( LI = NOEI ), Scenario B) or further all exceptional items ( LI = NOEI or EI, Scenario A) post-FRS3. LI is zero when CSI is zero and is scaled by lagged total assets.

49

Table 12 Panel A: Earnings persistence regressions for different levels of earnings

EARNINGS EARN EARNbXI EARNbNOEI

EARNbXI & EI

Pre-FRS3 0 0.023 0.021 0.020

1
0.521 0.585 0.636

Adj.R2 0.2641 0.3476 0.4237

Post-FRS3 0 0.026 0.022 0.019

1
0.491 0.640 0.728

Adj.R2 0.2393 0.3979 0.5190 3,807

EARNbEI
N

5,415

Diff./(p-value)a (b) (a) (c) (a) (d) (b) (e) (c) (d) (a) (e) (a) 0.115 (0.001) 0.237 (<0.001) 0.051 (0.183) 0.088 (0.051) 0.064 (0.098) 0.149 (0.002)

Panel B: Earnings persistence regressions for EARN and different levels of earnings (EARNADJ) with an interaction term capturing the change in persistence post-FRS3.
EARNADJi , t +1 = 0 + 1 EARNADJi , t + 2 FRS 3 EARNADJi , t + vi , t

EARNINGS EARN
EARNADJ1

0 (t-stat) 0.024*** (13.08)

0.022*** (11.91) 0.021*** (12.44) 0.020*** (12.86)

1 (t-stat) 0.516*** (20.38)

0.585*** (23.16) 0.584*** (23.72) 0.637*** (31.48)

2 (t-stat) 0.019 (0.57)

0.057* (1.91) 0.132*** (5.49) 0.090*** (4.15)

Adj.R2 0.2551

0.3661

EARNADJ2

0.4042

EARNADJ3 N
a

0.4583 9,222

p-value for difference in the persistence coefficients within each period is derived from a t-test using White standard errors. */**/*** significant at 0.1/0.05/0.01 levels (two-tailed). t-statistics in parentheses are calculated on NeweyWest standard errors that correct for heteroskedastic and autocorrelated residuals. The sample consists of 9,222 firmyear observations over the period 19861998 (pre-FRS10) for 914 UK non-financial firms with at least two observations in both the pre and post-FRS3 periods. EARN is earnings after extraordinary items. EARNbXI is earnings before extraordinary items. EARNbXI&EI is earnings before both extraordinary and exceptional items of the pre-FRS3 period. EARNbNOEI is earnings before non-operating exceptional items. EARNbEI is earnings before all exceptional items. For EARNbXI and EARNbXI&EI in the last pre-FRS3 accounting period EARNINGSt+1 equals EARNbNOEI and EARNbEI respectively. EARNADJ1 is EARNbXI pre-FRS3 and EARNbNOEI post-FRS3. EARNADJ2 is EARNbXI pre-FRS3 and EARNbEI post-FRS3. EARNADJ3 is EARNbXI&EI pre-FRS3 and EARNbEI post-FRS3. All variables are scaled by lagged total assets.

50