Do financially distressed firms misclassify core expenses?
Abstract
Purpose – This paper aims to examine whether financially distressed firms manipulate core or operating
income through the misclassification of operating expenses as income-decreasing special items.
Design/methodology/approach – This sample comprises firms in the USA with data from 1989 to
2010. The authors used the methodology given in McVay (2006) and multiple regressions.
Findings – Managers of financially distressed firms are more likely to inflate core or operating income as
compared to the healthy firms to meet or beat earnings benchmarks. They do so by misclassifying core or
operating expenses as income-decreasing special items. Specifically, core expenses are shifted to incomedecreasing special items like goodwill impairments, settlement costs, restructuring costs and write downs.
Practical implications – The paper sheds light on an important firm characteristic, financial distress
that intensifies classification shifting – an earnings management tool which auditors, investors and regulators
find tough to detect. The findings have implications for investors, as they fail to comprehend such shifting
(McVay, 2006); analysts, who issue forecasts based on street earnings; lenders, as distressed firms may be
concealing their true performance; and regulators, as the misclassification of income statement items is a
violation of accounting principles.
Originality/value – The authors extend the literature on accruals and real earnings management by the
financially troubled firms and present first evidence that the managers of such firms also manipulate core or
operating income through classification shifting.
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