Classification Shifting: Comprehensive Models to Estimate Unexpected Core Earnings

• In Event: Financial Accounting and Reporting 6

Abstract

McVay (2006) presents evidence that managers inflate core earnings by shifting operating expenses to special items. In this paper, we improve her model to estimate core earnings by controlling for firm’s fundamental operating performance effectively. McVay suggests that poorly performing firms, which are more likely to report income-decreasing special items, may elect to temporarily cut discretionary expenses leading to positive association between income-decreasing special items and unexpected core earnings. This positive association may then be incorrectly inferred as evidence of classification shifting. Hence, we control for those managerial actions which can impact the level of discretionary expenses and inventory, in order to estimate unexpected core earnings. Using modified models, which exhibit better explanatory and forecasting power, we continue to find evidence of classification shifting for our full sample (1990-2010). We find that McVay’s model seems to overstate magnitude of shifting due to insufficient control for performance, and likelihood of presence of poorly performing firms in the sample. Her model also fails to show classification shifting using shiftable income-decreasing special items, while proposed models are able to do so. When we use special item subtypes reported by Compustat from 2001 onwards, we find that classification shifting continues to exist in the recent period (2001-2010) and in fact, its magnitude has increased. Our models also capture classification shifting during the financial crisis (2008-09) when comparatively higher percentage of firms reported a negative special item. Overall, our models improve identification and understanding of classification shifting.

Authors

• Neerav Nagar, Indian Institute of Management–Calcutta

• Kaustav Sen, Pace University