Informativeness of Multiple-step Income Statement v.s. Sing-step Income Statement

Description

We propose to contrast the usefulness of the two income statement classificationschemes, by nature or by function, in facilitating earnings forecasting. Both U.S. GAAPand IFRS in the U.K. allow firms to use either by-nature or by-function classificationscheme. However, IFRS requires firms to provide additional disclosure on the nature ofexpenditures when they choose the by-function scheme (IAS1).Revenues and expenses can be classified by nature (e.g. revenue, labor costs,depreciation, and utilities) and presented in a single-step format, or by function (e.g.sales, cost of goods sold, operating expenses and non-operating expenses) and presentedin a multiple-step format. Each classification scheme has its advantages anddisadvantages. For example, for the by-function classification, users may better predictnext period’s expenses if the expenses related to continuing operations and related todiscontinued operations are disclosed separately; however, for the by-natureclassification, users may not be able to assess the continuation of an expense (e.g. laborcosts) if part of the expense is related to discontinued operations. On the other hand,the by-function classification may be less reliable because the distribution ofexpenditure by function involves subjective judgment. Moreover, managers mayopportunistically shift revenue and expenses around to overstate earnings from coreactivities.There are ample studies on the usefulness of by-function earnings components;however, no studies contrast the usefulness of these two schemes. We will first contrastthe usefulness of these two schemes for a sample of US and UK firms in earningspredictability (e.g. earnings forecast accuracy). We will then evaluate if the additionalrequirement by IFRS for by-function scheme users (IAS1) generates a superiorperformance for the UK sample relative to their US counterparts.Recent anecdotal evidence of SEC pursued cases on misclassifications of incomestatement items also highlight the inherent problems of the by-function scheme.Therefore our study has important implication to the capital market participants andaccounting policy making.