Abstract
In income classification shifting, firms shift recurring income components (in core earnings) that are income reducing to items commonly assumed to be nonrecurring (special items) to increase core earnings, which are used by analysts and investors to forecast future earnings and value a firm. Some special items tend to extend over multiple quarters and are more amenable to classification shifting because it is easier to shift core expenses into those items (continuous special items). Nevertheless, as the recurrence of special items increases, the market perceives them more like recurring earnings components (Cready et al. in Account Rev 85(5):1577–1615, 2010), which reduces the benefits of classification shifting. Therefore, we hypothesize that when special items are continuous and first in a sequence of quarterly continuous special items, firms are more likely to use them to shift income than when continuous special items are last in the series. Our results confirm our expectations. The findings highlight that the location of a continuous special item in a sequence of continuous special items affects the likelihood of income classification shifting.
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Notes
For brevity, we often use the term ‘special items’ to mean both special items reported in Compustat and discontinued operations.
Moreover, lack of disclosure quality in discontinued operations affects analysts’ earnings forecast accuracy (Beyer et al. 2021).
Fan et al. (2010) also find that classification shifting is used to meet zero earnings and 1-year ago same quarter earnings.
Givoly and Hayn (1996) classify special items into three groups based on the degree of managerial discretion in timing and magnitude. Examples of non-discretionary special items are litigation settlements and foreign currency translation gains and losses while gains and losses on the sale of operating assets and investments, and inventory liquidation gains/losses are examples of semi-discretionary special items. Examples of discretionary special items are restructuring charges and asset write-offs.
McVay (2006) argues that certain special items are more susceptible to classification shifting than others. Specifically, she classifies property, plant, and equipment write-offs, goodwill write-offs, and losses on asset sales as non-shiftable special items and all other special items (including restructuring charges and merger-related costs) as shiftable special items.
On the other hand, Lin and Yang (2006) document that analysts revise their forecasts more negatively for first-time annual restructuring firms than for firms with prior annual restructuring charges. A potential explanation is that the first restructuring charge provides more of an earnings surprise to analysts.
The remaining categories of special items are extinguishment of debt, reversal of restructuring and acquisition costs, settlement special items, sale of assets, asset write-downs, in-process research and development expense, extraordinary items, goodwill impairment, and other special items.
All variables used in our regressions, except for indicator variables, are winsorized at the 1st and 99th percentiles to control for outliers.
We use the Fama–French (1997) 48 industry classifications.
We need to go back to 2000 to retrieve variables for quarters q−1 and q−4.
We consider both negative and positive special items because firms are still able to shift core expenses into special items that are overall income increasing.
A series can be for one or more periods. Therefore, some sample observations are classified as both the first and the last in a series.
The Sarbanes–Oxley Act (SOX) provided sweeping changes to financial reporting and auditing of publicly traded companies. Congress passed it in 2002 in response to pressure to pass measures that would improve the credibility of financial reporting. Results from Cohen et al. (2008) suggest that firms switched from accrual-based to real earnings management following SOX, likely due to increases in financial reporting regulation. It follows that firms could have changed their classification behavior following SOX. The increased financial reporting regulation could have reduced classification shifting and/or a switch from accrual-based earnings management could have increased classification shifting. Furthermore, Kolev et al. (2008) show that Regulation 401b of SOX regulated the usage of non-GAAP reporting. The paper’s findings suggest that this led to the unintended effect of more classification shifting with GAAP financial statements.
We begin with 2001 because detailed special items in Compustat became available starting 2001.
For all special item related variables, we set any missing observation to zero.
P values are based on one-tailed tests.
Four quarters per year for 17 years.
In addition to the requirements UECE > 0 and I/B/E/S actual earnings > GAAP actual earnings.
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Acknowledgements
The authors thank the Editor-in-Chief (Dr. Cheng-few Lee), an anonymous referee, Jose Vega, participants at the 2019 American Accounting Association Southwest Region meeting, participants at the 2020 Hawaii Accounting Research Conference, and participants at the 2023 Korean Accounting Association conference for comments and suggestions that have improved this paper.
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Appendices
Appendix 1: continuity of special items (compustat industrial quarterly file)
Count of firm-quarters with new special items | Count of firm-quarters with new special items that continue in the following quarter(s) | Percent of firm-quarters with new special items that continue in the following quarter (%) | Average number of quarters that new special items last | ||
|---|---|---|---|---|---|
(1) | DOQ | 13,154 | 9268 | 70 | 6.32 |
(2) | AQPQ | 14,914 | 7416 | 50 | 3.31 |
(3) | RCPQ | 21,900 | 10,311 | 47 | 3.62 |
(4) | DTEPQ | 20,134 | 5438 | 27 | 1.58 |
(5) | RRPQ | 5731 | 1466 | 26 | 1.60 |
(6) | SETPQ | 17,180 | 4262 | 25 | 1.62 |
(7) | GLPQ | 19,763 | 4478 | 23 | 1.43 |
(8) | WDPQ | 23,115 | 4280 | 19 | 1.33 |
(9) | RDIPQ | 2440 | 450 | 18 | 1.31 |
(10) | XIQ | 4257 | 582 | 14 | 1.25 |
(11) | GDWLIPQ | 11,199 | 1223 | 11 | 1.16 |
(12) | SPIOPQ | 22,657 | 6373 | 28 | 1.71 |
This appendix presents the count of firm-quarters with new special items, the count and percent of those firm-quarters that continue to have the same type of special item in the following quarter, and the average number of quarters that a new special item lasts. We utilize the universe of the Compustat Industrial Quarterly file from 2001 to 2017. A firm quarter is deemed to have a new special items if there is no special item of the same type in the previous quarter. DOQ is discontinued operations, AQPQ is acquisitions and mergers, RCPQ is restructuring costs, DTEPQ is extinguishment of debt, RRPQ is reversal of restructuring and acquisition costs, SETPQ is the sum of all settlement special items, GLPQ is gain or loss on sale of assets, WDPQ is asset write-downs, RDIPQ is in-process R&D expense, XIQ is extraordinary items, GDWLIPQ is goodwill impairments, and SPIOPQ is other special items,
Appendix 2: sample selection criteria and procedures
Selection criteria | Observations | ||
|---|---|---|---|
Total number of U.S. firm-quarters in Compustat from 2001 to 2017 | 767,387 | ||
Less: | Number of firm-quarters in financial services and utilities | 184,469 | 582,918 |
Less: | Number of firm-quarters with annual sales of less than $1 million | 327,832 | 255,086 |
Less: | Number of firm-quarters that had a change in fiscal year end | 166 | 254,920 |
Less: | Number of firm-quarters with missing current quarter or lagged accounting variables for the core earnings regression | 155,776 | 99,144 |
Less: | Number of firm-quarters with missing return data on CRSP | 1259 | 97,885 |
Less: | Number of firm-quarters in an industry with less than 15 observations | 6616 | 91,269 |
Less: | Number of firms-quarters with missing I/B/E/S data | 20,829 | 70,440 |
Less: | Number of firm-quarters with missing institutional ownership data | 9540 | 60,900 |
Less: | Number of firm-quarters with missing current quarter or lagged accounting variables for the logistic regression | 31,167 | |
Final sample | 29,733 |
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Shin, H., Lacina, M. & Pan, S. The order in a series of continuous special items and the likelihood of income classification shifting. Rev Quant Finan Acc (2024). https://doi.org/10.1007/s11156-024-01265-5
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DOI: https://doi.org/10.1007/s11156-024-01265-5