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Classification Shifting for Earnings Management Case Study

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Updated: Jul 13th, 2020

Introduction

The number of companies that are involved in the earnings management procedures is constantly growing. As a result, the methods, motivations, and approaches to managing the companies’ income change and evolve.

The thresholds that companies are trying to meet are to report the positive profit and to meet the expectations of the analysts and other external audiences (DeFond and Park 122). To analyze how the techniques and the tools used in the earnings management differ depending on the different factors, it is important to see different managerial incentives in each particular case (McVay, Nagar and Tang 574). However, one of the most widely used tools of earnings management is the classification shifting, and the reason for its common use in such practice is the possibility of its application alongside both real financial actions and managed accruals.

Motivation, hypothesis, and descriptive statistics

The first one among the number of methods of earnings management is accruals management. It is a means, for the executives, to boost the earnings during the current fiscal period by borrowing the profits from the future periods. The revenues from the upcoming fiscal periods are accelerated, and the manager reports the future earnings as the current ones and the non-received shipments as the present ones (Hand 599). However, in a long-run company’s performance, such a method creates a disproportion since future earnings would be significantly lower than the current profit.

Another kind of earnings manipulation is the real financial actions, management of the real activities, such as discretionary expenditures and sales discounts used to enhance the sales (Healy and Palepu 409). On the outside, such manipulations can increase the net income, but they demand additional expenditures and costs from the company.

If both options are, for some reason, unavailable to the managers, they often apply the classification shifting, which can be defined as “the intentional misclassification of items within the income statement” (McVay 505). The classification shifting is also often used in financial reporting as an additional means to reach the financial benchmarks and to ensure the managerial benefits (Klein 398). It is especially relevant since classification shifting deals with the core expenses and special items. They are the most evident items in the financial reports.

While the special items tend to be infrequent, the stability of the company’s performance is based on the steady core expenses. Thus, the hypothesis is that the managers misclassify them as special expenses to cut the expenditures. The data from 76,901 companies’ financial reports demonstrated that nearly 2,7% of the items that needed to be reported as core expenses were misclassified (McVay 509).

Measuring shifting of classification, test design, and results

During the measuring of the classification shifting, it was discovered that core expenses are most often misclassified as serial special items and Compustat special items, such as restructuring and merging expenses (McVay 510). Another result is that the level of classification shifting increases when it helps to meet the analysts’ expectations. There is also an association of the income management with the benefits of the executives themselves, as well as the connection between the performance of the company and its agreement with the analysts’ forecasts.

Conclusion

In conclusion, different incentives of the companies’ executives correspond to the different use of earnings management techniques. The classification shifting is a means of misreporting the core expenses of the company as the special items to meet the analysts’ forecasts.

Works Cited

DeFond, Mark, and Chul Park. “Smoothing Income in Anticipation of Future Earnings.” Journal of Accounting and Economics 23.2 (1997): 115-139. Print.

Hand, John. “1988 Competitive Manuscript Award: Did Firms Undertake Debt-Equity Swaps for an Accounting Paper Profit or True Financial Gain?” Accounting Review 1.1 (1989): 587-623. Print.

Healy, Paul, and Krishna Palepu. “Information Asymmetry, Corporate Disclosure, and the Capital Markets: A Review of the Empirical Disclosure Literature.” Journal of Accounting and Economics 31.1 (2001): 405-440. Print.

Klein, April. “Audit Committee, Board of Director Characteristics, and Earnings Management.” Journal of Accounting and Economics 33.3 (2002): 375-400. Print.

McVay, Sarah. “Earnings Management Using Classification Shifting: An Examination of Core Earnings and Special Items.” Accounting Review 81.3 (2006): 501-531. Print.

McVay, Sarah, Venky Nagar, and Vicki Wei Tang. “Trading Incentives to Meet the Analyst Forecast.” Review of Accounting Studies 11.4 (2006): 575-598. Print.

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