Managing Earnings Using Classification Shifting: Evidence from Quarterly Special Items

Abstract

McVay (2006) concludes that managers opportunistically shift core expenses to special items to inflate current core earnings, resulting in a positive relation between unexpected core earnings and income-decreasing special items. However, she further notes that this relation disappears when contemporaneous accruals are dropped from the core earnings expectations model. McVay (2006) calls for research to improve the core earnings expectations model and to provide additional cross-sectional tests of classification shifting. Using a core earnings expectations model that is not dependent on accrual special items, we show that classification shifting is more likely in the fourth quarter than in interim quarters. We also find more evidence of classification shifting when the ability of managers to manipulate accruals appears to be constrained and in meeting a range of earnings benchmarks. Overall, our evidence provides broad support for McVay’s (2006) conclusion that managers engage in classification shifting. Our study also sheds new understanding of the conditions under which managers are more likely to employ classification shifting.

Classification Shifting in the Income-Decreasing Discretionary Accrual Firms

“…When she removes contemporaneous accruals from the model the positive relationship disappears and becomes negative. McVay (2006) and Fan et al (2010) explains this as a result of the mechanical relation between unexpected core earnings and accrual-based special items. Abernathy et al (2014) investigate the relationship between classification shifting and other two earnings management tools.…”

“…They use quarterly data and extend McVay's model by dropping current-period accruals. By using the extended model Fan et al (2010) find evidence of classification shifting between core earnings and special items. Barua et al (2010) examine classification shifting between core earnings and income-decreasing discontinued operations and find a positive relationship.…”

“…As the first evidence of classification shifting she finds a positive relation between unexpected core earnings and income-decreasing special items. Fan et al (2010) provide support to the classification shifting model of McVay (2006). They use quarterly data and extend McVay's model by dropping current-period accruals.…”

“…Classification shifting defined by McVay (2006) as the opportunistic misclassification of expense items within the income statement and received a greater degree of attention in the literature (McVay, 2006;Fan et al, 2010;Haw et al, 2011). McVay (2006 investigates whether managers reclassify core expenses to special items.…”

“…It is defined by McVay (2006) as the deliberate misclassification of items within the income statement. Some studies examined the misclassification of core expenses as income decreasing special items (McVay 2006;Fan, Barua, Cready & Thomas 2010), some as discontinued operations (Barua, Lin, & Sbaraglia, 2010), and some as non-operating expenses (Noh, Moon, Guiral, & Esteban 2014). Literature also provides extensive evidence for other two general earnings management tools: accrual management (Healy 1985;DeAngelo 1986;McNichols & Wilson, 1988;Jones 1991;DeFond & Jiambalvo 1994;Dechow, Sloan, & Sweeney 1995;Kothari, Leone, & Wasley, 2005) and real activities management (Roychowdhury 2006;Cohen & Zarowin 2010;Gunny 2010;Zang, 2011).…”