EXTRAORDINARY ITEMS AND INCOME SMOOTHING: A POSITIVE ACCOUNTING APPROACH.

This article presents study that examined classificatory choices within an explicit, incentives-based framework. The results obtained will provide an insight into the general applicability of positive accounting theory by evaluating its explanatory power in a hithero untested choice situation. The assumed object of smoothing in this study is the reported profit after tax, but before extraordinary items. This is chosen because, under U.K. GAAP, it provides the basis for the calculation of the earnings per share figure, a statistic regarded by many as a key financial ratio. The instrument of smoothing which we examine is the classification of items either above the line or below the line. In this study, we refer to exceptional and extraordinary items as discretionary classification items. We will show that in U.K. financial reporting they occur frequently and are of significant magnitude. The remainder of this paper is structured as follows. In the next section we (i) define earnings management, (ii) review positive accounting theory, which provides the general theoretical framework for this study, (iii) discuss the relationship, within this framework, between the accounting choice, earnings management and income smoothing literatures, and (iv) develop our model and hypotheses. In the third section we describe our measure of smoothing and detail our sample and methods. The fourth section contains results and discussion. The final section presents the conclusions.