Classificatory Smoothing of Income with Extraordinary Items.
The paper presents tests of whether extraordinary revenues and expenses are used to smooth ordinary or operating income over time. While the subject of income smoothing was discussed and tested previously, the role of extraordinary items never was tested for specifically and separately. This observation is most striking, particularly in view of the fact that by applying different smoothing mechanisms, extraordinary items can be used to smooth various series, such as net, ordinary or operating income. Although past studies assumed that smoothing is practiced in order to affect the income stream presumably utilized by financial statements users, the focus was exclusively on the net income numbers, when, in fact, ordinary income per share is the focal number of users of financial statements and therefore, should be the object of smoothing. Indeed, income smoothing could be designed to convey information relevant for the prediction of future earnings. In the present case, smoothing is used as a vehicle for management to convey its expectations within the framework of conventional accounting practices, which do not permit direct forecasts.