Classification shifting using discontinued operations and impact on core earnings: evidence from Japan

Abstract

Purpose This study aims to investigate whether managers of Japanese firms that adopt international financial reporting standards (IFRS) engage in earnings management by shifting core expenses to reported discontinued operations. Based on this purpose, the author also investigates the impact of continuing operations reporting on core earnings. Design/methodology/approach This study uses regression analysis mainly using the expected-core-earnings model (McVay, 2006) on a sample of Japanese firms adopting IFRS. The sample consists of 317 firm-year observations representing 48 Japanese firms that adopted IFRS from 2010 to 2018, noting that Japan has adopted IFRS since 2010. Findings The author finds that firms shift operating expenses of continuing operations to discontinued operations to increase core earnings. Additionally, the author desegregates reported discontinued operations into core and non-core earnings because previous literature assumes that firms engage in classification shifting using special items. Results reveal that firms use the classification shifting using negative non-core earnings of discontinued operations. Furthermore, the income-increasing discontinued operations negatively influence both current and future core earnings while income-decreasing discontinued operations do not. Research limitations/implications The result could rely on the efficiency of the expected core earnings model. The author intentionally use only the Japanese sample rather than a global sample to control the characteristics of each country that can be noise; it could be a bias of this study. Practical implications The author revealed that firms engaged in the classification shifting using negative non-core earnings of discontinued operations. Providing detailed information on discontinued operations, segmented core earnings and non-core earnings (special items) is necessary. Deficiency of details on discontinued operations can create information asymmetry between managers and investors. It can encourage managers to engage in opportunistically earnings management using discontinued operations, taking advantage of investors’ ignorance of the nature of the expenses allocated to discontinued operations. Social implications This study would be beneficial to investors by informing them of the potential usefulness and risks of IFRS because it is believed that IFRS is to be the predominant set of accounting standards in the world. Originality/value The author exposes a potential earnings management practice under IFRS by extending the literature on classification shifting through examining the relationship between unexpected core earnings and discontinued operations. The author extends prior research for classification, developing it to an investigation of the impact on core earnings, finding that income-increasing discontinued operations negatively influence core earnings, whereas income-decreasing discontinued operations do not. This study indicates that standard setters should pay close attention to the potential problems of line-item separations of discontinued operations.

How culture and legal environment affect classification shifting? Global evidence

“…Usman et al (2022) found that German firms engage in misclassification of core expenses, while Boahen and Mamatzakis (2021) and Nagar and Sen (2017) observed the same behaviour among Indian firms. Inoue (2021) discovered classification shifting among Japanese firms, while Athanasakou et al (2009) and Zalata andRoberts (2016, 2017) identified this practice among UK firms. Haw et al (2011) and Behn et al (2013) found evidence of misclassification of core expenses as non-recurring expenses among firms in East Asia.…”

“…Second, it investigates the impact of various national cultural dimensions on expense misclassification. Previous studies on classification shifting have mostly focused on individual countries, with limited attention given to the cross-country cultural dimension (Boahen and Mamatzakis, 2021;Inoue, 2021;Usman et al, 2022). Given that national culture does not vary over time within countries, previous studies could be subject to bias in empirical findings.…”