Direct and substitution effects of regulations impacting the scope for classification shifting

We exploit two historic changes to Australian accounting standards to examine the direct and substitution effects of regulations impacting the scope for classification shifting. First, we consider whether reforms to the standard prescribing the format of the income statement (AASB 1018) introduced during 2001/02 reduced the extent to which core expenses were opportunistically misclassified as ‘abnormal’ in an attempt to boost ‘core earnings’ (the ‘direct effect’), and whether any reduction in classification shifting behavior induced greater use of accrual-based earnings management (the ‘substitution effect’). We then examine the impact of the introduction of AASB 101 in 2005, which effectively reversed the constraints on classification shifting introduced in 2001/02. We find that classification shifting using abnormal items was significantly reduced following the 2001/02 reform. However, this reform also appears to have induced an increased use of accruals management to manipulate core earnings, thus potentially impairing earnings quality. We find some weak evidence of an increase in classification shifting behavior following the adoption of AASB 101, but no evidence of any substitution effects involving accrual-based earnings management.