Classification Shifting in an International Setting: Investor Protection and Financial Analysts Monitoring

Abstract

Prior research on publicly traded U.S. firms provides evidence that managers engage in classification shifting to opportunistically manage 'core' earnings. We extend this line of research in a broader international setting, by examining (1) whether the level of investor protection affects managers' decisions to engage in classification shifting behavior and (2) whether coverage by financial analysts mitigates this behavior. Based on an international sample of firms from 40 countries, we observe evidence consistent with classification shifting in both strong and weak investor protection countries using four separate measures of investor protection. We then explore the potential monitoring role of financial analysts in mitigating classification shifting. We provide evidence that higher financial analyst following mitigates classification shifting, primarily in weak investor protection countries. Overall, our results provide evidence of classification shifting in a broad international setting and evidence of financial analysts influence in reducing this form of earnings management.

Analyst Coverage and Earnings Management Using Classification Shifting

“…Prior studies on external monitoring factors and classification shifting provide mixed results: international studies (Haw et al, 2011;Behn et al, 2013) find external monitoring factors mitigate classification shifting, while Abernathy et al (2014) find external monitoring factors promote classification shifting when accrual-based and real earnings management is constrained. This study examines this topic from the perspective of analysts' monitoring effect in the United States.…”

“…Using an international sample, Behn et al (2013) finds that higher financial analyst following mitigates classification shifting in the countries where the investor protection is weak.…”

“…Prior studies on external monitoring factors and classification shifting provide mixed results: international studies (Haw, Ho, & Li, 2011;Behn, Gotti, Herrmann, & Kang, 2013) find that external monitoring factors mitigate classification shifting, while Abernathy, Beyer, and Rapley (2014) find that external monitoring factors promote classification shifting when accrual-based earnings management and real earnings management are constrained. Using a sample of firms in the United States, this study finds a positive association between classification shifting and an external monitoring factor: analyst coverage.…”

“…Haw, Ho, and Li (2011) find that stronger legal institutions and Big 4 auditors mitigate classification shifting in East Asian countries. Another international study by Behn, Gotti, Herrmann, and Kang (2013) finds that higher financial analyst following mitigates classification shifting in the countries where the investor protection is weak. However, using the data of firms in the United States, Abernathy, Beyer, and Rapley (2014) find that classification shifting is more likely to be used when institutional ownership is higher.…”

Does Religion Matter for Earnings Management?

“…Following prior research (Behn, Gotti, Herrmann, and Kang, 2013;Dechow et al, 2012;Haw, Ho, and Li, 2011;Xie et al 2003), we compute discretionary accruals using the modified-Jones model with working capital accruals for each firm year observation and two digit SIC code and industry. The results are presented in Table 10 below.…”