Accounting for Extraordinary Items in Singapore: Empirical Findings and International Implications
Choo Teck Min Peter Lee Lip Nyean
This study examines the needfor a more stringent accounting standard to restrict the usage of extraordinay items (El) in Singapore given recent international reforms in El reporting. It seeks to identify signs of the abuse of EI and to predict the impact of a more stringent El accourlting standard on the jinancial Statements of firms in Singapore. Data from the Stock E,ychange of Singapore (SES) were examined to analyse statistical trend.s and test three hypotheses to determine if there was any manipulation of EI. The findings generally indicate no evidence of income smoothing or earnings management with respect to El. This may be due to the jhct that Singapore has a fairly ejjicient capital market and companies perceive no incentilâ€™e to manage the earnings figure via El. Thus. the implementation of Provisional Statement of Accounting Standard (PAS) 19 to restrict the usage of EI would not necessarily have had an unusually great impact on the attitude of,firms toward accounting ,for El. It would, howe\aer, act as a further deterrent to any abuse and enable better comparison between financial statements. On the other hand, it could lead to more erratic earnings and perhaps sudden share price movements. Finally, the implications for international harmonisation of the withdrawal of PAS 19 are also discussed. Key Words:
Items; Income Smoothing; Earnings Management.
INTRODUCTION In the past two decades, the reporting of extraordinary items (EI) has been the subject of reform by a number of accounting standard setting bodies in various countries. The Accounting Principles Board (APB), a committee of the American
Choo Teck Min l Room 01-A-08, Nanyang Business School, Nanyang Technological University, Nanyang Avenue, Singapore 639798, Republic of Singapore. Email: email@example.com. Journal of International Accounting, Auditing & Taxation, 7(2):2 15-232 All rights of reuroduction Coovright 0 1998 bv JAI Press. Inc.
ISSN: 1061-9518 in any form reserved.
Institute of Certified Public Accountants (AICPA) was the first to initiate the reform when it issued Opinion No. 30 to replace Opinion No. 9 in 1973. The accounting standard setting boards in Australia, U.K. and Hong Kong followed the initiative by the APB, albeit much later. In 1992, the International Accounting Standards Committee (IASC) revised International Accounting Standard (IAS) 8 which covers the reporting of EI, among other things. The common thread among these revised accounting standards is that EI are now defined narrowly and restricted to rare events such as natural disasters and expropriation of assets. Prior to the revisions, EI have been defined broadly. This resulted in abuse in the use of EI adjustments as well as inconsistencies in the reporting of earnings. The restricted definition of EI in IAS 8 (revised) effectively abolished EI from the income statement. The reform in the reporting of EI by the IASC and other national accounting standard setting bodies is a positive step in the global harmonisation of the accounting treatment of EI. With the deregulation and globalisation of financial and capital markets, international investors have more investment opportunities and the harmonisation in accounting standards would contribute towards enhancing the international comparability of financial statements. Singapore is a member of the IASC and has been adopting IAS standards with minimal amendments since the 1980s. Following the issue of IAS 8 (revised), the Institute of Certified Public Accountants of Singapore (ICPAS) issued Provisional Statement of Accounting Standard (PAS) 19 in July 1994. PAS 19 was intended to replace the existing standard, Statement of Accounting Standard (SAS) 8 which was based on the previous IAS 8. However, on 29 December 1995 the ICPAS withdrew PAS 19. It is conjectured that the restricted definition of EI in the proposed standard had met with considerable objections from the business community, which had also occurred in Hong Kong, as the reason given for the withdrawal was that it was not in accordance with â€œaccepted practice.â€? The main objective of this study is to evaluate the need for the proposed restricted usage of EI and the possible impact that it may have on Singapore companies. The first part of this study reviews the abuse of EI reporting as an intemational issue and how the various national and international accounting standard setting bodies dealt with the problem. The second part analyses the incidence of EI reporting among Singapore companies and the results of tests of three hypotheses. The third part discusses the implications of the withdrawal of PAS 19 on Singapore as a financial center and on Singapore companies. An International Perspective Of EI Reporting The income statement is arguably the most important financial statement, at least to investors. Investors use the reported income for the period to assess the performance of the enterprise and to form or revise their expectations of the
Accounting for Extraordinary
income of the enterprise in the future. An important and often controversial aspect of the income statement is the reporting of EI. Conventional accounting practice reports EI “below the line” and they are usually excluded in the computation of earnings per share (EPS) and other financial ratios such as return on investment (ROI) which are widely used by investors. As a result, investors tend to fixate on net profit after tax (the bottom line) and pay little or no attention to EI although the latter form part of the enterprise’s performance for the period. So, what constitutes an EI is an important question that can affect the reported income. Prior to the reform in EI reporting, accounting standards defined EI broadly. As a result, companies have considerable discretion in classifying items as “extraordinary” or part of ordinary operations. APB Opinion No. 9 defined EI, “of a character signijicantly different from the typical or customary business activities ofthe entity.” The IASC’s IAS 8, issued in 1978, defined EI in a similar manner as “ . . .gains or losses that derive from events or transactions that are distinct from the ordinary activities of the enterprise and therefore not expected to recur frequently or regularly” (para. 3). In these two standards, as well as in other standards such as the U.K. Statement of Standard Accounting Practice (SSAP) 6, it is left to management to determine what constitutes an entity’s “ordinary or customary activities.” Further, both APB Opinion No. 9 and IAS 8 implied that an item that occurs infrequently does not necessarily mean that it should be classified as an EI. The broad definition of EI has resulted in inconsistent treatment of EI among different companies or even among different periods of the same company. Different companies treat certain ambiguous income statement items differently. This has caused great difficulty in assessing and comparing financial performance across companies and over time. However, the more serious concern is the potential for abuse through EI adjustment in the income statement. A broad definition of El provides an opportunity for a company to use its discretionary power to report its performance in a more favorable light which may be misleading to users of financial statements. For example, CMB Asia Ltd., a company listed on the Stock Exchange of Singapore (SES) tried to treat staff retrenchment, bad trade debts, customs duties and write down of fixed assets and inventory, altogether amounting to $5.8 million, as EI. However, its auditors insisted that the charges arose from ordinary activities and thus should be part of the operating results (Cua 1995). There is evidence in the accounting literature that such manipulation of reported earnings using EI adjustment is an international problem. One form of earnings manipulation is income smoothing (Briedleman 1973; Copeland 1968). Management’s desire to report a smooth trend in ordinary income could be motivated either by the wish to enhance the perceived reliability of the trend data of ordinary income for the purpose of predicting cash flows, or the wish to eliminate “noise” from the ordinary income stream so as to enhance the predictability of
AUDITING & TAXATION, 7(2)
earnings (Barnea, Ronen and Sadan 1975). Dempsey, Hunt and Schroeder (1993) examined the EI reporting practices among 248 U.S. firms in the 1960s when management had considerable discretion with respect to the definition of what constitutes an EI and its placement in the financial statement, that is, whether in the income statement or retained earnings statement. Their conclusion was that firms exhibited the tendency to report losses as EI and gains as part of ordinary income. Similarly, Bamea et al. (1976) in another study of U.S. companies reported that “We tested whether EI were used in classificatory smoothing. Our results are, indeed, consistent with the hypothesis that managements behaved as if they classified items which potentially could be labeled as extraordinary so as to dampen the fluctuations over time of income before EI.” In Australia, Craig and Walsh (1989) undertook a study of listed Australian companies’ practice of reporting EI and concluded “there is evidence that certain classes of larger companies have used material EI adjustments to indulge in manipulative, profit smoothing, creative accounting practices.” Further evidence of using EI as a smoothing instrument was provided in a study of 228 British companies by Beattie, Brown, Ewers, John, Manson, Thomas and Turner (1994). The study found that smoothing behavior was positively associated with earnings variability and when managers of companies have share options. Besides income smoothing, firms may use EI adjustment to facilitate “big bath” accounting which usually refers to the practice of depressing the current year’s earnings (or increasing losses) in the hope that a rapid increase in income will be reported in subsequent years. Evidence of big bath accounting using EI is provided in a study of Australian companies by Walsh, Craig and Clark (1991). International
Reform In EI Reporting
The AICPA was the first professional accounting body to recognize the need to reform the reporting of extraordinary items. In 1973, the APB issued Opinion No. 30 which significantly narrowed the definition of EI and required that an item should meet two requirements: it should be “highly unusual in nature” and “infrequent in occurrence.” In addition, APB Opinion No. 30 provided additional guidance on what is extraordinary by identifying those items that do not qualify as extraordinary, among which are write-downs or write-offs of tangible and intangible assets, gains or losses from disposal of a segment of a business and effects of strikes. As a result, EI became extremely rare in the income statements of U.S. companies except for those items that are required by other accounting standards to be classified as “extraordinary,” for example, gains on the extinguishment of debt. While APB Opinion No. 30 did limit the abuse in the reporting of EI in the U.S., it also has drawn criticisms from the business community and some writers. Among the criticisms are that it resulted in greater volatility of the reported net
Accounting for Extraordinary items
incomes of companies, thereby reducing the predictive value of income statement data (Barnea et al. 1975; Cameron and Stephen 1991). The IASC followed the lead of APB Opinion No. 30 when it reissued IAS 8 in 1992. Under the revised standard, EI are defined as: “. . income or expenses that arise from events or transactions that are clearly [emphasis added] distinct from the ~rdi~1.a~ activities of the enterprise and therefore not expected to recur frequently or regularZy. ” The word “clearly” is added to reduce me degree of generality in the original definition of EI. In a step further, the term “ordinary activities” are defined in a broader sense. They are defined in paragraph 6 as “. . .activ~ties ~Ih~ch are unde~aken by apz e~te~rise as part of its business and such related activities in which the enterprise engages in furtherance OJ incidental to, or arising from clearly [emphasis added] those activities. ” Paragraph 12 of IAS 8 (revised) states that “only on rare occasions does an event or transaction give rise to an extraordinary item.” IAS 8 (revised) effectively reduces the possibilities to two situations: expropriation of assets and natural disasters (para. 14). Other events, such as litigation settlements and disposals of plant, property and equipment, which used to be classified as EI, are now re-classified as abnormal or exceptional items which form part of the operating profit figure. A Look At Other Countries In the United Kingdom, Financial Reporting Standard (FRS) No. 3 (Accounting Standards Board 1992) replaced Statement of Standard Accounting Practice (SSAP) No. 6 (Accounting Standards Committee 1974) as the accounting standard on EI. It became effective for accounting periods ending on or after June 22, 1993. The aspect of FRS 3 that received the most publicity was the restriction on the use of EI. Coopers and Lybrand carried out a survey of the early adoption of FRS 3 (Holgate and Roberts 1993). Out of 111 top U.K. companies with years ending between September 1992 and March 1993, 69 companies (62%) had adopted FRS 3 early. Some of the rem~ning companies did not adopt FRS 3 early because they had “practical problems of obtaining data in time” or they found that the adoption was not “attractive.” In sum, the results of the survey showed mat the adoption of the re-defined EI in U.K. was quite smooth. In fact, many U.K. companies seemed to show keen interest in the adoption, only a few needed time to adjust. In Australia, the AASB 1018 was revised in 1992 along similar lines and implemented without any major problems. In Hong Kong, Lynn and MeGuinness (1995) explored the incidence, nature, and impact of EI on earnings. At the time of their research, the Hong Kong accounting standard on EI was still the old standard (similar to SAS 8). A total of 374 companies listed on the Stock Exchange of Hong Kong (SEHK) were examined over a five-year reporting period and the findings were as follows:
AUDITING & TAXATION, 7(2)
25% to 36% of Hong Kong companies have reported EI in their accounts across the five-year reporting period; * Most of the EI have a positive impact on income (i.e., gains). The percentage of positive cases ranged from 55% to 79% of all EI cases recorded; Most of the El arose from asset sales and discontinuance of business or product lines; There was no evidence of “income smoothing.” Income smoothing is a creative accounting technique of manipulating the profit and loss accounts in order to project a consistent or smooth trend of reported income. l
Overall, there was rather “liberal” usage of EI in Hong Kong and hence, the implemen~tion of the restricted usage of EI was not welcomed by many Hong Kong companies. Some firms’ responses to the new EI standard (which had similar recommendations to that of PAS 19 in Singapore) were so adverse that even the threat of audit qualifications could not convince them to comply with the re-defined EI rules (Bloomberg Business News 1994). Hence, the reactions of Singapore companies to PAS 19 (which is identical to IAS 8 (revised) are of much interest and concern to international investors interested in investing in Singapore.
This section focuses on the reasons underlying the usage of EI across firms and through time. Industrial and commercial companies listed on the Stock Exchange of Singapore (SES)‘s main board comprised the sample for this study. All info~ation related to EI was collected from the companies’ annual reports on a three-year basis (1992-1994). It included the components and descriptions of EI, as well as the companies’ EPS. The information was then summarized in tables and tests of three hypotheses were subsequently performed. The areas of interest revolve round the reasons why management would prefer one disclosure method over another, what motivations are involved, and whether they constitute earnings management. In considering these issues, three hypotheses are presented. Based on the empirical tests that are carried out, evidence is presented as to whether accusations of earnings management such as income smoothing (Lynn and McGuinness 1995) are substantiated. Hypothesis
The first hypothesis focuses on income smoothing. The possibility that smoothing occurs is based on the premise that management tries to smooth
Accounting for Extraordinary
reported earnings to maximize their self-interests. By smoothing income levels, the reported earnings pattern would appear less volatile than the real earnings pattern. This appearance of lower volatility may lower the market’s perception of default risk. The lower the perceived default risk, the higher is the firm value and the assessment of managers’ performance. Shareholders also like smoothed income if the firm is assessed as higher in value and having greater growth potential leading to higher share prices. Thus, Revsine (1991) argues that sh~~holders would have incentives to condone the income smoothing behaviors of managers and favour the choice of “loose” accounting practices (as availed by the ambiguous definition of EI) that permit such behaviours. In the context of EI, in a period of low operating earnings, management may have the incentive to classify tr~sa~tions such as losses from sales of assets or other expenses as extraordin~ to increase the operating earnings to the desired level. Conversely, in a period of high operating earnings, management may decide to classify unusual gains as extraordinary to lower the operating earnings again to the desired level (Craig and Walsh 1989). Managers may also try to smooth reported earnings in order to maximise their bonuses. This would especially be the case where the managers’ bonus schemes have upper and lower bounds (Healy 1985). Further, managers may also smooth income to minimise their tax exposure from such bonuses. Hence, there exists in SAS 8 an avenue whereby management can exercise their classificatory discretion to present desired results. To test the incidence of income smoothing which also reduces the volatility of reported earnings, profit and volatility of earnings (as measured by the coefficient of variation) before and after EI are compared. Therefore, the first hypothesis, in alternative form, is: Hl:
Companies use El to smooth income and as a result there is a significant difference in profit and volatility of earnings before and after EI.
The second hypothesis is concerned with management’s incentives to select accounting procedures that allow it to “manage” the earnings figure. The reasons for doing so vary. It might be due to the existence of a bonus plan that is tied to the reported earnings figures. This is often referred to as the bonus plan hypothesis (Watts and Zimmerman 1986). Further, the performance and stewardship of the management are usually assessed based on the firm’s earnings results. Thus, management may tend to classify transaction gains as operating to boost the net operating results and losses as ex~aordin~ to avoid affecting the operating results adversely. Another reason why the operating results are so critical is because of the calculation of EPS. EPS is required to be computed by all listed companies in Sin-
gapore. It is based on the ratio of net earnings after tax and minority interests but before taking into consideration EI, over the number of shares in issue and ranking for dividend in the period. Therefore, it is obvious that anything classified as EI would have no effect on the EPS figure. Therefore, management may tend to classify gains as operating to boost the EPS figure and losses as extraordi~a~ to avoid reducing the EPS, especially when the EI loss is significantly large in amount. It may even turn a profitable scenario into an unprofitable one. EPS is an important figure because of the emphasis being placed on it in the calculation of PE ratios that are used extensively by most investors to assess the value of the firm. The second hypothesis, in alternative form, is as follows: H2:
The amount of losses classified as EI is significantly higher than the amount of gains classified as EL
The choice of disclosing transaction gains or losses as operating or extraordinary is very much susceptible to personal and subjective judgement due to the lack of concrete guidelines on its dichotomisation. As a result, transactions of a similar nature may be classified differently by different companies even though they may be in the same or similar industry. If this is so, comparability of financial statements may be seriously impaired to the extent that they may become misleading to investors. It is very much because of this reason that the ICPAS released PAS 19 to restructure and standardise the reporting method for such non-recurring items. Hypothesis 3 seeks to determine whether such a problem exists and the extent to which it exists. All the EI transactions that were identified in the annual reports of the sample companies over the three years selected were broadly classified into five categories and coded. Only four out of the five categories are tested separately to determine whether their classification as extraordinary or operating are subjective in nature. Category 5 basically includes all EI that are not included in any of the first 4 categories and hence is too general to draw any meaningful conclusions. It is postulated that because much subjective judgement is involved in classifying certain transactions as extraordinary or operating, the likelihood of a certain transaction being classified as extraordinary or operating is almost equal and therefore fairly arbitrary. Thus, the third hypothesis, in alternative form, is presented as follows: H3a:
There is an equal likelihood of an asset sale or discontinuance being classified as either operating or extraordinary.
There is an equal likelihood of diminution as either operating or extraordinary.
of value of assets being classified
Accounting for Extraordinary
There is an equal likelihood of share of EI in related companies being classified as either operating or extraordinary.
There is an equal likelihood operating or extraordinary.
costs being classified as either
DATA ANALYSES ANDRESULTS Descriptive Statistics The research was conducted through a study of a sample of companies listed on the SES Main Board. The Industrial and Commercial sector of the SES Main Board was picked to form the sample of companies to be reviewed. It consists of 157 companies and it is the largest sector of the SES Main Board. The annual reports of these companies from 1992 to 1994 were reviewed. Out of the 157 Industrial and Commercial companies reviewed, only 135 have complete income statements for all three years. The remaining companies mostly had reported their financial statements in foreign currencies or had changed their accounting periods. Only a very small number of companies’ financial statements could not be obtained. Three important aspects of EI of these companies are considered-the incidence rate, size and nature of EI. These will provide insight into the reasons for the appearance of EI in the companies’ accounts. Moreover, more information can be obtained through the analysis of any patterns or trends across the three-year period. Table 1 depicts the rate at which EI have appeared in the accounts of the Industrial and Commercial companies from 1992 to 1994. It shows that, over the three-year period, EI have a high incidence or occurrence rate of 85.9% in the companies’ accounts. It means that for every 100 Industrial and Commercial companies listed on the SES Main Board, about 86 of them have classified part of their operations as “extraordinary.” This figure is higher than that in Hong Kong reported by Lynn and McGuiness (1995) for the 1987 to 1991 period (61.2%). Even when the analysis is broken down into a yearly basis, as shown in Table 1, the incidence rate still exceeds 50 percent for each year. However, a decreasing trend of incidence can be observed. Although the number of companies which have reported EI in their accounts have not differed greatly, those with complete income statements in the SES have increased from year to year. As a result, the incidence rate of EI as a percentage of Industrial and Commercial companies with complete income statements has fallen. Hence, it can be deduced that companies have been relatively consistent in their yearly reporting of EI. However, the newly listed companies have lower inci-
TABLE 1 Incidence of Extraordinary Items (EI) in the 1992-1994 Accounts of Industrial & Commercial Companies Listed on the Stock Exchange of Singapore (SES) Main Board Number of Industrial & Commercial companies listed on the SES Main Board as of 2618195 Number of Industrial & Commercial listed companies with complete income statements in 1992-1994 period Number of industrial & Commercial listed companies with one or more EI reported in 1992-l 994 accounts Incidence rate for at least one El in Industrial & Commercial companiesâ€™ 1992-l Y94 accounts Number of Industrial & Commercial companies with complete income statements and have one or more El reported in 1992- I994 accounts. Number of Industrial & Commercial companies with complete income statements Number of Industrial & Commercial companies with missing income statements* Total number of Industrial & Commercial companies Incidence rate of Industrial & Commercial companies with one or more EI reported in 1992--l 994 accounts Note:
(cS(b) 85.9% Iy94
*h&sing income Statements due to financial statements reported in foreign currencies, changes in accounting periods or unavailability of information.
dence rates of EI in their accounts. This explains the decreasing percentage trend of incidence. Table 2 shows the mean values and the standard deviations of the operating profit and EI over the three-year period. The mean values are derived by dividing the combined balances of the operating profits or EI of the sample companies over the number of companies. With reference to the mean values of EI shown in Table 2, one can see an erratic movement in its trend. They expand about fourteen times in 1993 but later reduce by slightly more than three times in 1994. Looking at the mean values of operating profit in Table 2, one can see a moderate (45%) increase in 1993 and very little change from 1993 to 1994. Extraordina~ items generally can be classified as either positive or negative, which is shown in Table 2. Positive cases refer to gains or additions to profits while negative cases refer to losses or deductions from profits. Looking at the absolute numbers, we can see that the number of companies with positive balances in their EI accounts is increasing over the years, while those with negative EI balances are decreasing. As a result, the percentage of companies with positive EI balances increased while that of compares with negative EI balances decreased. In 1992, the number of negative EI cases exceeded the positive
Accounting for Extraordinary
TABLE 2 Descriptive Statistics of Extraordinary Items which Appear in the Accounts of Industrial & Commercial Companies Listed on the SES Main Board
Number of Industrial & Commercial companies with complete income statements Mean Value of Operating Profit (S$‘OOO) Standard Deviation of Operating Profit (S$‘OOO) Mean Value of EI (SS’OOO) Standard Deviation of El (S$‘OOO) Number of companies with positive Els (a) Number of companies with negative Els (b) Number of companies with El 0 (c)=(a)+(b) Number of companies with EI = 0 (d) Number of companies with complete income statements (e)=(c)+(d) Percentage of positive EIs (a)/(c) Percentage of negative EIs (b)/(c)
43,357.16 136J58.60 X.525.09 68,230.9 I 39 31 70 56 126
40,356.46 132,500.50 2,372.06 2 I ,003.60 42 29 71 63 134
29.990.88 93,897.52 625.1 I 1 1,608.37 32 41 73 37 II0 43.84% 56.16%
cases. The latter caught up in 1993 and the gap was widened in 1994. Hence, the belief that companies tend to classify losses as extraordinary and gains as operating does not appear to hold, at least in 1993 and 1994 as shown in Table 2. In further investigating the nature of the EI, all the EI in the annual reports of the Industrial and Commercial companies were broadly classified into five main categories. These categories were then coded as shown in Table 3. Category 1 includes the sale of long-term assets and the disposal or discontinuance of subsidiaries, associated companies, and termination of product lines. Category 2 encompasses write-downs or write-offs in the values of long-term investments, subsidiaries, associated companies and freehold or leasehold properties. Category 3 stands for shares of EI reported in subsidiaries. Category 4 includes restructuring expenses as well as those related to aborted acquisitions. Lastly, Category 5, the residue, is made up of the remaining items such as write-offs of goodwill on consolidation and patents, staff retrenchment benefits, and litigation settlements. Table 3 displays the frequencies with which the five categories of profit and loss items appear as extraordinary or operating. Category 1 has the highest frequencies under both headings. This implies that asset sales and discontinuance are subjective in treatment because they have relatively similar likelihood of being reported as extraordinary or operating. The other subjective or ambiguous category is Category 5. On the other hand, however, items in Categories 2, 3 and 4 appear much more frequently as EI than operating ones. Although they are less subjective than the other codes, they also cannot be classified as EI if PAS 19 recommendations had been approved by the ICPAS.
TABLE 3 Description of Categories Used for Profit and Loss Items, and the Frequencies which They Appear As Extraordinary or Operating EXTRAORDINARY Category Description
I 2 3 4 5
Asset Sale/Discontinuance Diminution in value of assets El in subsidiaries Reorganisation Others
91 55 I9 I4 41 220
41.4 25.0 8.6 6.4 18.6 1oo.o
IO3 17 2 7 42 _l.J_!
60.2 9.9 1.2 4.1 24.6 1oo.o
Hypothesis 1 In the first test of Hl, income smoothing is posited to occur when a statistically significant difference is observed between profit before and after EI at the 5% level of significance. In the second test of Hl, the coefficient of variation (CV) for earnings before and after EI are compared across three years of available earnings data for the sample companies. This approach was also adopted by Lynn and McGuinness (1995). This measure, which is the ratio of standard deviation of earnings to mean earnings, captures the volatility of earnings for a given mean dollar amount of earnings. If CV of earnings after EI adjustments is significantly lower than CV of earnings before EI, it implies that EI are used to facilitate income smoothing. The results of the tests for Hl are shown in Table 4. From these tests, there is insufficient evidence to support Hl and income smoothing in Singapore by listed companies. The two-tail paired t-tests on the difference between profit before EI and profit after EI yield t-values of -0.56, -1.40 and -1.31 for 1992, 1993 and 1994 respectively.â€™ The test on the difference between the mean profit before and after EI for the three years combined yields a t-value of -1.73, which is insignifiTABLE 4 Profit, Mean Profit and Coefficient of Variation Before and After EI Over 3 Years Variable
Profit before EI (PBEI) Profit after El (PAEI) Protit before EI (PBEI) Profit after El (PAEI) Profit before El (PBEI) Profit after EI (PAEI) Mean Profit before EI Mean Profit after El C.V. before El C.V after El
1992 1992 1993 1993 1994 1994 1992-94 1992-94 1992-94 1992-94
26365.7X 26990.88 34832.07 43357. I6 37984.40 40356.46 29396.09 33704.95 0.43 I.51
92799.96 93897.52 I 19266.5 0 13655X.6 0 128162.4 0 132500.5 0 88 132.05 91580.25 I .22 8.80
I IO II0 126 126 134 134 109 I09 109 IO9
Accounting for Extraordinary
TABLE 5 of Mean Losses and Gains Classified as EI Over Each of 3 Years (1992-1994) Mean
Mean El loss
Mean EI loss Mean El gain
I 876.6 I 2Y034.26
124X I .43
*One-tail f-tests significant
3263 I .2X
at 5% level (critical t-value =
cant at the 5% level. The results are contrary to the prediction of income smoothing by management. They suggest that in general, management does not use EI disclosure as an instrument to smooth income. Also, the one-tail test on the difference between the coefficient of variation of profit before and after EI yields a t-value of -1.30 (p-value = 0.098) which is insignificant. The direction of the means, however, seems to indicate that profit after EI is actually more volatile than profit before EI. Therefore, there is little evidence of management using EI transactions as an instrument to smooth income and to reduce volatility. Hypothesis
The second hypothesis is concerned with whether EI reported are predominantly gains or losses. It was postulated that management could classify gains as operating and losses as extraordinary to boost the EPS figure. The results from our tests conducted indicate otherwise. These are shown in Table 5. There is insufficient evidence to support the view that the amount of losses classified as EI are significantly greater than the amount of gains classified as EI. In all the three years of comparison, the mean EI loss is not significantly higher than the mean EI TABLE 6 Proportion of Coded Transactions Being Classified as Operating Items or EI Over Each of 3 Years (1992-1994) Cat.
P(as El only) n(EI only)
P(as op only) n(op only)
II I 6
*Two-tail Z-tests significant
at 5% level (critical Z-value = 1.96)
6 1 1
66 20 20
12.52* 17.44* 3.42*
gain at the 5% level of significance. In fact, the mean EI gain is greater than the EI loss for all three years. The above results can also be deduced from the descriptive statistics shown in Table 2. In Table 2, the mean value of EI is positive for each of the three years from 1992 to 1994. Hypothesis 3 The third hypothesis concerns the subjective nature of EL Due to the subjective nature of certain transactions that can be classified as either EI or operating items, the need for standards like PAS 19 has been advocated to provide consistent and comparable financial statements. The tests conducted on 4 out of the 5 categories of items that are often classified as EI indicate that 3 out of the 4 categories are not subjective. The results are shown in Table 6. For Category 1, which represents asset sales and discontinuance in general, the Z-value of -2.73 provides evidence that H3(a) is not supported, the probability of classifying asset sales or discontinuance as operating or extraordinary are not approximately equal (i.e., they are significantly different). The same applies for Categories 2 (Z = 12.52) 3 (Z = 17.44) and 4 (Z = 3.42). Here again, we do not find evidence of abuse of SAS 8. It should be noted that the above tests are conducted based on proportions excluding the “both” category in Table 6. Even though the results of the tests suggest that the treatment of asset sales/discontinuance is not subjective, we noticed that the number of companies reporting such transactions as both operating and extraordinary are considerably large (about 69%). Therefore, if we had classified each of these companies’ treatment of asset sales/discontinuance as an EI and also as an operating item (as in Table 3), the results would have indicated otherwise. This seems to suggest the subjectivity of such transactions. This incongruence may be explained by the fact that by taking out the number of companies reporting the transactions as both operating and extraordinary, we have reduced the incidence of companies reporting such transactions as extraordinary or operating significantly. Also, the categorization of various assets such as fixed assets, property and land under one common heading may lead to conclusions that are too general. This problem however, does not pertain to categories 2, 3 and 4. Discussion of Findings There is a growing concern that EI are being used as a convenient avenue for smoothing income or projecting greater earnings. Standards imposing restrictions on the usage of EI are not new and have been in effect for some time now in countries like the U.S., U.K. and Hong Kong. Reactions from accounting practitioners, though, have varied widely from eager acceptance to outward resentment. This
Accounting for Extraordinary
study was motivated by these international developments and the realization that there may be some abuse of the existing local standard relating to the use of EI. The withdrawal of PAS 19 on December 29, 1995, further increased the significance of this study, casting doubt over whether Singapore truly needs a more stringent standard to regulate the use of El. The findings from this study generally dispel the notion that firms in Singapore are engaged in manipulation of the earnings figure through the way they account for EI. There is, in particular, no evidence of management using EI as an avenue to smooth income or reduce the volatility of their earnings. Volatility and profits after EI were on average not significantly different from volatility and profits before EI. These findings were realized in spite of the fact that the motivation to practice income smoothing may be great. Smoothing income to show more stable earnings would give the market a more favorable perception of the firm’s default risk and increase the firm’s worth while granting managers higher rewards in terms of bonuses. A possible reason for the above observed phenomena is that management may regard the stock market in Singapore to be relatively efficient. This implies that information which has no cash flow effects does not have any share price effects. Investors are deemed to be able to “see through” any artificial attempts to smooth or manipulate the earnings figure. Since the classification of EI is merely a matter of presentation and not cash flow related, in an efficient market management is not concerned with whether transactions are being reported as operating or extraordinary as long as full disclosure of the transaction is made. Contrary to our expectations, the amount of losses from EI does not exceed the amount of gains from EI. In fact, both the results from the test of H2 and the descriptive statistics indicate that, on average, the EI gains are higher than EI losses over the three years. These results are in line with the contention that management does not make an effort to hide losses in EI. They are also consistent with the implications of Hl which suggests that the capital market is efficient. This may explain why management does not maximize the operating profit figure by putting in gains and taking out losses. Such classificatory adjustments do not have cash flow effects and hence do not affect the values of firms in an efficient market. Hence, management may not be involved in such adjustments as they may believe that such adjustments are immaterial. Although it has been identified earlier that SAS 8 provides avenues for manipulation of operating profits, the results show that it has not been abused. This would lead one to believe that any regulation on the use of EI would not affect the current practice greatly with regard to these items. Thus, the decision to adopt or abandon PAS 19 would not have had a very great impact on the accounting practice of most firms. The conversion from its provisional status to
AUDITING & TAXATION, 7(2)
an actual accounting standard would have merely eliminated some possible avenues of creative accounting. However, it is highly possible that most firms prefer and enjoy the flexibility in the current definition of EI as per SAS 8, which might explain the withdrawal of PAS 19. Another explanation is that management may believe that classifying certain items as EI would enhance the predictive value (or relevance) of the â€œprofit after tax and before Elâ€? figures (Cameron and Stephens 1991). The tests on subjectivity with regards to the classification of items as operating or extraordinary indicate that the treatment of three out of four categories of items are quite consistent and not very subjective. These three categories include diminution in the value of long-term investments, EI in subsidiaries and reorganization expenses. Category 1, consisting of sale of long-term assets and discontinuance, however, has an interestingly high rate of incidence in terms of the number of companies reporting this type of transaction as both operating and extraordinary. This suggests a high degree of subjectivity in the treatment of asset sales and discontinuance. Based on these results, any new standard on EI ought to specifically address this category of items as their current treatment as operating or extraordinary items varies significantly between and within companies. Due to the lack of specific concrete guidelines on EI, companies may be applying their own subjective or arbitrary rules to determine how these items are accounted for.
Implications for Singapore and Singapore Companies Singapore occupies a central position as the financial and business hub of southeast Asia, one of the most important and fastest growing economic regions in the world in recent years. Besides being the preferred choice of MNCs for the location of their regional headquarters, it is also one of the leading financial centers in Asia, after Tokyo and Hong Kong. In order to maintain and enhance the growing reputation of its financial market, it is important that Singapore continues to adopt measures that maintain the confidence of international investors. This would include, among other things, maintaining a high standard of financial reporting. The decision not to reform the reporting of EI, as has been undertaken by other national and international standard setting bodies, may not be viewed positively by international investors particularly when Hong Kong has already done so despite initial opposition from certain sections of the business community. The withdrawal of PAS 19 appears to be a step backwards for international harmonization. Given the
Accounting for Extraordinary
present pattern of high incidence of EI, comparability of the financial statements of Singapore companies with companies in similar industries in other countries could be affected. Although our studies indicate little signs of earnings management based on the totality of evidence gathered, adopting a more restrictive standard is a definite way of limiting, if not totally eliminating, earnings management possibilities. Adoption of PAS 19 will curb these problems since there will be greater constraints and less flexibility in the use of EI. Taken together, all these will give investors greater confidence in the published financial statements. However, implementing PAS 19 has its share of drawbacks too. PAS 19 may be a little too restrictive in its efforts to limit the list of possible EI, reducing the options essentially to only expropriation of assets and natural disasters. The adoption of PAS 19 would lead to erratic earnings as infrequent items which were earlier classified as EI would now be put under operating income. This would include items like discontinuance of a product line or disposal of a subsidiary. Currently, such rare occurrences are not included and the operating income figure is shielded from sudden large fluctuations. With the proposed definitions of EI, however, earnings over a number of periods may become erratic due to the sudden huge amounts involved by including once excluded items. Our explanations of the current behavior of accounting practitioners included the assumption of Efficient Market Hypothesis (EMH). It is assumed that Singapore, being a financial centre, has a fairly efficient market and transactions with no cash-flow implications will have minimal effects on share prices and firm value. However, if this assumption is relaxed, the introduction of PAS 19 would have an impact on the EPS figures. This would affect share prices of listed companies. Theoretically, there is no change of fundamental or intrinsic value because it is just a reclassification of items. However, assuming inefficient markets, there may be a severe impact on share prices because investors usually rely on the EPS as an indicator of the financial status of a company. If a new EI standard were to be proposed and implemented, comparative EPS figures should be disclosed in the initial few years of implementation. That is, two sets of EPS figures ought to be reported. One set would be the EPS figures calculated based on a new and restricted definition of EI while the other set would be the EPS figures calculated based on the existing definition of EI in SAS 8. This will smooth the implementation process of a new standard on EI and allow firms and their investors time to adjust to the transition. The disclosure of comparative EPS figures will also prevent naive investors from making misleading interpretations based on just the new EPS figures.
AUDITING & TAXATION, 7(2)
This is essentially testing the null hypothesis
that EI is not significantly
different from zero.
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