Management of Core Earnings Using Classification Shifting Around Seasoned Equity Offerings

Abstract

McVay (2006) shows that managers can raise reported core (pro-forma) earnings by shifting core expenses to special items. While the bulk of the literature (e.g. Teoh, Welch, and Wong, 1998; Cohen and Zarowin, 2010) has exclusively focused on accrual- and real activities-based earnings manipulation methods, we provide the first known evidence of the manipulation of core earnings in the equity issuance context. To the extent that investors focus solely on non-GAAP 'core' earnings, managers have incentive to inflate core earnings rather than bottom-line return on assets (which remains unaffected) through accrual-based earnings management. If successful, this leads to investors misinterpreting the issue prospects and subsequently overvaluing new issues. Using a core earnings expectations model, which builds on the approach of McVay (2006) and extended by Fan, Barua, Cready, and Thomas (2010) with quarterly data, we provide evidence supportive of manipulation in the form of a positive association between income-decreasing special items and unexpected core earnings in the fourth quarter. We also find that issuers’ choices to use classification shifting or accrual earnings management strategies depends on auditor’ characteristics, flexibility and detection probability. Finally, we compare the effect of the two means of manipulation strategies and provide evidence that classification shifting is less likely than accruals management to be associated with post-issue performance declines.