Core Earnings Management: How Do Audit Firms Interact with the Balance Between Classification Shifting and Accruals Management?

Abstract

This study examines the interaction of audit firm characteristics with two core earnings management tools: classification shifting (CS) and core accruals management (CACM). CS occurs when management intentionally misclassifies recurring operational expenses as special items to inflate perceptions of core earnings. A Norwegian sample of companies, with forthcoming equity issues and acquisitions, reveals that CS substitutes for CACM for clients of Big 4 and industry-specialized audit firms. By contrast, CS complements CACM for clients of non-Big 4 and non-specialized audit firms. The level of auditor-provided non-audit services during a forthcoming equity issue, a measure of economic bond potential, also interacts with CS and CACM, though this interaction is different for clients of Big 4 and non-Big 4 audit firms. The overall results suggest that auditor incentives may support tolerating CS, which raises a question about the effectiveness of current accounting and auditing standards.