35
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at the 1% and 99% level to avoid outliers.
Table 10 provides the regression results whether there is a relationship between special items (SIt) and unexpected core earnings (UE_CEt) where UE_CEt is calculated from the expected model with working capital accruals instead of total accruals. Table 10 shows that after the replacement of total accruals by working capital accruals special items are still positively associated with unexpected core earnings (coefficient of 0.117; p-value <0.001).
Therefore, Table 10 shows that our results of the main analysis were not mainly driven by a bias of the McVay (2006) model.
Table 10
Robustness Analysis McVay Model (2006)
Regression of Unexpected Core Earnings on Special Items Dependent variable: UECEt
Independent variables Coefficient t-statistic p-value
Intercept –0.036*** –6.96 <0.001
%SIt –0.117*** –6.39 <0.001
SIZEt –0.005*** –7.29 <0.001
LEVt –0.006*** –1.06 0.392
CFOt –0.019*** –1.19 <0.001
ROAt –0.143*** –8.22 0.015
BMVt –0.002*** 2.16 0.480
Adjusted R2 2.02%
All variables are winsorized at the 1% and 99% level. Variables are defined in Table 2. *, **, *** are significant at the 10%, 5%, and 1% level, respectively.
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5 Conclusion and Discussion
This study focuses on classification shifting as an earnings management tool. More specifically, I investigate whether U.S. firms see classification shifting as a viable earnings management method and the association of board independence on this form of earnings management. The bulk of the literature on earnings management focuses on accrual-based earnings management and real earnings management, but according to McVay (2006) a third possible form is classification shifting. Classification shifting differs from the other earnings management methods, because it does not change bottom line earnings.
First, I investigate whether U.S. firms use classification shifting as an earnings management method. I test to what extent special items predict the level of unexpected core earnings. I find evidence that special items are positively associated with unexpected core earnings. This suggests that some firms shifted some of their core expenses to special items to inflate core earnings. The association between unexpected core earnings and special items can also be caused due to real economic events, for example immediate benefits of the restructuring charge. Therefore, it is expected that the misclassification in the current year reverses in the following year. The findings provide evidence that special items are negatively associated with the unexpected change in core earnings. This indicates that indeed a part of the misclassification of core expenses as special items reverses in the following year. These results conclude that in the presence of classification shifting, firms have (1) higher core earnings than expected and (2) a lower change in core earnings than expected in the following year. These results are consistent with McVay (2006) and indicate that U.S. firms see classification shifting as a viable earnings management method.
Next, I investigate the association of board independence on classification shifting practices. The findings provide evidence that CEO duality (CEO is also the chairman of the board) is positively associated with classification shifting. This confirms that classification shifting is more prevalent in firms with a dual CEO in comparison to firms with a non-dual CEO. I also find that the proportion of independent directors on the board is not associated with classification shifting. This means that firms with a higher proportion of independent directors on their board are not less likely to engage in classification shifting practices.
Finally, the results may be biased due the total accruals used in the models of McVay (2006) to determine expected core earnings and the expected change in core earnings.
Therefore, a sensitivity test is performed where total accruals are replaced by working capital accruals. After this replacement, I still find a strong significant association between unexpected
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core earnings and special items. This confirms that the results of this study are not driven by a model bias.
This study contributes to prior research, because it shows the relevance of classification shifting as an earnings management tool. It also expands the limited available literature on classification shifting and how it can be mitigated. The results can provide insights for investors, because classification shifting is prevalent in the U.S. Classification shifting results in an increase of core earnings, so investors should take in consideration that the core earnings number within the income statement may be higher due to the misclassification of core expenses as special items. In addition, this study is also relevant for standard setters because the results contain information about the effect of board independence on classification shifting. This information may be helpful in decision making regarding corporate governance or financial reporting related standards.
There are some limitations to this study as well as possible extensions for further research. First, this study focuses on the effect of board independence on classification shifting where board independence is only measured by two proxies: CEO duality and the proportion of independent board members. Another limitation of this study is that classification shifting is only measured among U.S. firms. Therefore, future research might investigate a broader set of internal corporate governance mechanisms that may affect classification shifting practices. It is also recommended to increase the sample size by firms outside the U.S. to investigate whether classification shifting is used worldwide as an earnings management tool.
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