Extraordinary Items and Income Smoothing: A Positive Accounting Approach

Abstract

This is an empirical study of single‐period income smoothing which uses an incentives‐based model to explain classificatory choices. An index is constructed to measure the smoothing effect of these choices. Weighted least squares regression results indicate that classificatory choices consistent with smoothing are more likely to be observed in firms with high earnings variability, high dividend payout, substantial managerial holdings of share options and diffuse share ownership. The existence of material scope for smoothing strengthens these findings. The model as a whole is statistically significant and, although the proportion of variability in smoothing explained is modest, it compares very favourably with other accounting choice studies. The relationship between smoothing and alternative earnings management strategies, including big bath accounting, is explored.

Determinants of different accounting methods choice in Tanzania

“…The contracts are, nevertheless, efficient as they result in firm value maximization. In practice, it is difficult to distinguish hypotheses based on this perspective from those generated in the opportunistic behaviour setting (Beattie et al, 1994;Florou, 2004).…”

“…Managers' holdings of shares and share options and through the effect on the value of their human capital affect the share value wealth. It follows, therefore, that managers have incentives to make choices which maximize the firm's direct cash flows and hence firm value (Beattie et al, 1994).…”

“…Previous studies show that managers may choose income increasing or income decreasing accounting policies in reporting financial results (Beattie et al, 1994;Astami & Tower, 2006;Bowen & Shores, 1995).These studies also examine a number of factors that influence the managers' incentives for accounting choice. However, there are reasons to suggest that more research is required.…”

“…Our motivation is therefore to gather evidence about the factors which influence managerial action. The accumulation of evidence from such studies facilitates the development of a theory to explain accounting practice (Beattie et al, 1994). We are also motivated by the fact that accounting information is used by rational investors in their investment decisions, but usefulness of the information to investors depends on how managers or preparers behave.…”

“…In examining managers' accounting policy choice, we apply the positive accounting theory (Watts and Zimmerman, 1986) as in other previous studies (Beattie et al, 1994;Astami & Tower, 2006). The basic assumption of positive accounting theory is that managers (as agents) are rational individuals who are concerned with furthering their own self-interests.…”