The association between classificatory and inter-temporal smoothing: Evidence from the UK's FRS 3

Financial Reporting Standard No3 (FRS 3): Reporting Financial Performance, which came into force in 1993, increased UK firms' discretion in classifying exceptional items. We examine how this increased discretion affected their use of classificatory smoothing and inter-temporal smoothing through abnormal accruals to offset temporary shocks in performance and highlight sustainable profitability. Descriptive and multivariate analysis reveals a significant decline in income smoothing using abnormal accruals after FRS 3. The decline occurs in firms that used classificatory choices to a greater extent after FRS 3 to smooth income and is robust to controls for the effect of concurrent corporate governance regulation. Our results suggest that enhancing disclosure and discretion to classify non-recurring items within the income statement can reduce the costs to firms of achieving their income smoothing objectives.