The effect of the interest coverage covenants on classification shifting of revenues

Abstract

While prior studies focus on real/accrual-based earnings management and expense misclassification to investigate earnings manipulation in avoiding covenant violations, this paper extends such research in a new direction. In particular, it examines whether firms employ classification shifting of revenues when they are subject to interest coverage EBITDA-based covenants close to their threshold values or limits. This earnings management tool allows firms to increase reported EBITDA by misclassifying non-operating revenues as operating revenues to remain within covenant limits that include EBITDA. Using a sample of 559 UK listed firmyears for the period 2005-2014, it establishes that the use of classification shifting of revenues is high when interest coverage covenants are close to their limits. Further analysis suggests that firms also employ revenue shifting when all their loan covenants are EBITDA-related.

Forcing responsibility? Examining earnings management induced by mandatory corporate social responsibility: evidence from India

“…Under CS, managers misclassify income statement line items to report a favorable operating performance of their firms. For instance, firms misclassify operating expenses as non-operating expenses (expense misclassification) to report inflated operating profits (McVay, 2006; Fan et al , 2010) or misclassify non-operating revenue as operating revenue (revenue misclassification) to report inflated operating revenue (Malikov et al , 2018, 2019).…”

“…SIZE is measured as the natural logarithm of total assets. Second, we control for the degree of financial leverage ( LEV ) because levered firms are more likely to do revenue misclassification to avoid violating earnings before interest expenses, taxes, depreciation and amortization (EBITDA)-based covenants (Malikov et al , 2019). LEV is the proportion of total outside liabilities to total assets.…”

Do CEO social connections promote corporate malpractices? Evidence from classification shifting

“…Athanasakou et al, 2009;Boahen & Mamatzakis, 2020;Fan et al, 2010;Haw et al, 2011;McVay, 2006;Zalata & Roberts, 2017) by being the first to provide evidence that the social capital of the CEO matters to a firm's classification shifting outcomes. Prior studies in this literature show that equity market incentives (Athanasakou et al, 2009;Fan et al, 2010;Haw et al, 2011;Zalata & Roberts, 2017), board characteristics (Zalata & Roberts, 2016), debt market incentives (Fan et al, 2019;Malikov et al, 2019), and religious social norms (Boahen & Mamatzakis, 2020) affect firms' classification shifting. In this study, we focus on the social capital of the CEO and show that this is a key factor that drives the widespread malpractice of classification shifting.…”

Do inflowing sophisticated investors induce classification shifting? New evidence from market liberalisation in China

“…This less visible earnings management tactic has drawn growing attention in contemporary accounting research. Relevant studies have largely focused on the incentives behind classification shifting and mechanisms for curbing such opportunistic reporting behaviour (McVay, 2006;Fan et al, 2010Fan et al, , 2019Haw et al, 2011;Behn et al, 2013;Abernathy et al, 2014;Roberts, 2016, 2017;Fan and Liu, 2017;Joo and Chamberlain, 2017;Malikov et al, 2019;Seve and Wilson, 2019).…”