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.
This study examines whether firms with private loan contracts that contain debt covenants based on earnings before interest, taxes, depreciation, and amortization (EBITDA) are more likely to misclassify core expenses as special items (i.e., classification shift). Misclassifying core expenses as income-decreasing special items allows the firm to increase EBITDA and thereby potentially avoid debt covenant violations. Consistent with our expectation, firms misclassify core expenses as special items when at least one EBITDA-related financial covenant is close to being violated. In addition, classification shifting is more prominent when financially distressed firms are close to violating at least one EBITDA-related covenant. Whereas prior research on classification shifting focuses primarily on equity market incentives (e.g., meeting analysts’ earnings forecasts), our study extends this research to private loan contracts to highlight that creditors also affect classification shifting. Classification shifting appears to be an additional earnings management technique used by managers to avoid debt covenant violations. This paper was accepted by Shivaram Rajgopal, accounting.
Prior studies of classification shifting in the income statement conclude that managers misclassify core expenses as special items to inflate reported core earnings (McVay 2006;Fan, Barua, Cready, and Thomas 2010). These studies do not distinguish between the core expense components-cost of goods sold (COGS) and selling, general, and administrative expenses (SGA). This study models COGS and SGA separately, and investigates managers' misclassification of COGS versus SGA to meet different profitability benchmarks. We find that COGS (but not SGA) misclassification is associated with just beating the benchmark of gross margin four quarters earlier. In comparison, both COGS and SGA misclassification are associated with just beating the benchmarks of zero core earnings, prior-year core earnings, and analyst earnings forecasts in the fourth fiscal quarter. We also investigate real activities management (RAM) of COGS and SGA to meet benchmarks, and find that managers engage in RAM of COGS to achieve the gross margin benchmark, but not core earnings benchmarks. We demonstrate that unexpected SGA contains a significant misclassification effect distinct from RAM, suggesting that future RAM research should consider controlling for expense misclassification. Overall, our study extends prior literature on both classification shifting and RAM.Classement inappropri e des charges de base a titre d' el ements exceptionnels : coût des produits vendus ou frais de vente, frais g en eraux et administratifs ? R ESUM ELes etudes qui ont port e jusqu'ici sur le changement de classement dans l' etat des r esultats aboutissent a la conclusion que les gestionnaires classent indûment les charges de base dans la cat egorie des el ements exceptionnels de mani ere a gonfler les b en efices publi es provenant des activit es principales (McVay, 2006;Fan, Barua, Cready et Thomas, 2010). Dans ces etudes, aucune distinction n'est faite entre les el ements qui composent les charges de basecoût des produits vendus (CPV) et frais de vente et frais g en eraux et administratifs (FVGA). Les auteurs mod elisent le CPV et les FVGA isol ement et se penchent sur le classement inappropri e du CPV et des FVGA auquel proc edent les gestionnaires pour atteindre diff erents indicateurs de r ef erence au chapitre de la rentabilit e. Ils constatent que le classement inappropri e du CPV (mais non des FVGA) est associ e a l'objectif de d epassement minimal de l'indicateur de r ef erence que repr esente la marge brute affich ee quatre trimestres plus tôt. En revanche, le classement inappropri e tant des FVGA que du CPV est associ e a l'objectif de d epassement minimal de l'indicateur de r ef erence que repr esentent des b en efices nuls associ es aux activit es principales, les b en efices de l'exercice pr ec edent provenant des activit es principales, et les pr evisions de r esultats des analystes pour le quatri eme trimestre de l'exercice. Les auteurs etudient egalement la manipulation des activit es r eelles en vue de modifier le CPV et les FVGA de telle so...
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