The Rise and Demise of Abnormal Items

Abstract

How components of profit should be classified and displayed in financial reports has been the subject of much debate and has been given considerable attention by accounting standard-setters. The debate has centred on distinguishing profit from ordinary operations and profit arising from events outside the ordinary operations of the business, identifying which components of profit from ordinary operations should be disclosed separately, and the form those disclosures should take. Over time, Australian accounting standards have changed in their requirements for distinguishing between extraordinary items and operating profit, and for separate disclosure of certain components of operating profit. Until 1989, Australian companies frequently reported extraordinary items, distinguishing them from profit from ordinary operations. Perceptions of companies opportunistically classifying income and expense items as extraordinary led to the standard-setters tightening the definition to the extent that items would meet the definition only in very rare cases. In examining reporting practices before and after this change, Houghton (1994) observed a significant increase in the frequency of profit and loss (P&L) items being classified as 'abnormal items' after 1989, and found that they were, on average, losses, whereas they were previously, on average, gains. Classification of P&L items as abnormal attracted the attention of regulators and the media in the late 1990s, and concerns were raised that items that should have been classified as part of profit from normal operations were being classified as abnormal to improve reported 'normal' earnings (see McLean 1999). When the Australian Accounting Standards Board (AASB) proposed to remove the abnormal items classification from accounting standards, some respondents to the exposure draft supported the move, while others argued that it inhibited companies' ability to indicate the underlying transitory nature of some items. Revisions to accounting standards nevertheless proceeded and, from 2001, Australian companies were no longer permitted to classify P&L items as abnormal. The controversy surrounding the perceived abuses of classifying P&L items as abnormal, and the opposition to removal of the abnormal classification from accounting standards, raises the question of whether the change was justified. This paper addresses this question by examining whether there was an increase in the frequency and magnitude of abnormal items over the seven-year period up to the removal of the 'abnormal' classification from accounting standards.