An examination of the impact of the changes to regulations affecting the scope for income classification shifting in Australia
Date
2016
Authors
Seve, Folototo
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Abstract
This study examines the impact of amendments to Australian
accounting standards governing the classification and reporting
of non-recurring components of earnings on firms’
classification shifting practices, and on the propensity to
engage in other earnings management such as accrual-based and
real earnings manipulation to improve core earnings. The study
investigates the impact of three regulatory changes which have
the potential to affect firms’ earnings management behaviour
and thus the quality of earnings. I first investigate whether the
amendments to the standard AASB 1018 Profit and Loss Accounts,
effective for financial periods ending on or after 30 June 2002
and which restricted the scope for reporting and classifying
abnormal items on the income statement, reduced the incidence of
classification shifting. I then investigate whether the
implementation of AASB 101 Presentation of Financial Statements,
effective for financial periods starting on or after 1 January
2005 (upon IFRS adoption), and which relaxed prior restrictions
on classifying and reporting non-recurring items, induced greater
classification shifting. I also examine whether AASB 5 Noncurrent
Assets Held for Sale and Discontinued Operations (effective at
the same time as AASB 101), which increased the scope for
classifying and reporting discontinued operations on the income
statement, resulted in firms opportunistically misclassifying
these items to increase core earnings.
I then investigate the impact of each of the three regulatory
reforms on firms’ use of alternative earnings manipulation
methods, because there is evidence that a change in regulatory
regime could impact firms’ alternative earnings management
behaviour. For example, Cohen, Dey and Lys (2008) document an
increase in the use of real earnings management to improve
earnings following the reduction in accrual-based earnings
management as a result of the Sarbanes-Oxley Act 2002. Therefore,
there is potential for firms to substitute earnings management
methods as a result of the changes to the scope for
classification shifting. I expect that the restriction on
classification shifting provided by AASB 1018 in 2002 may give
rise to greater accrual-based and/or real earnings management by
firms, whilst the greater scope for classification shifting
provided by the later reforms may result in the reduction in use
of accrual-based and/or real earnings management.
To examine the first three research questions, I develop models
of classification shifting from McVay (2006) and Barua, Lin and
Sbaraglia (2010). I then use difference in differences designs to
investigate the extent of firms’ classification shifting in the
post-reform periods relative to the pre-reform periods. I also
use a difference in differences design and develop models to test
the impact of the regulations on firms’ alternative earnings
management behaviour.
My results show that there is no evidence of classification
shifting following the 2002 amendment while there is indirect
evidence of firms engaging in classification shifting using
abnormal items, and strong evidence of classification shifting
using discontinued operations following the 2005 amendments.
However, tests of the impact of the reforms on alternative
earnings management behaviour show that the restriction on
classification shifting by the 2002 reform resulted in greater
accrual-based manipulation to increase core earnings, while there
is no such evidence of real earnings manipulation. There is
evidence of a reduction in accrual-based manipulation and sales
manipulation following the increased scope for classification
shifting (post-2005) but there is no such evidence of real
earnings management via discretionary expenditure reduction.
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earnings management, classification shifting, regulatory changes, alternative earnings management methods
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