Misclassifying Core Expenses as Special Items: Cost of Goods Sold or Selling, General, and Administrative Expenses?

Abstract

Prior classification shifting studies pool core expenses together and conclude that managers misclassify core expenses as income-decreasing special items to inflate reported core earnings (e.g., McVay 2006; Fan et al. 2010). Their core expense measure combines cost of goods sold (COGS) with selling, general and administrative expenses (SGA). This study models COGS and SGA separately and investigates the choice of COGS versus SGA misclassification that managers make to meet different profitability benchmarks. We find that when reported gross margin shows a small increase from four quarters ago, COGS (but not SGA) misclassification is more prominent. In comparison, both COGS and SGA misclassification are more prevalent when firms report small core earnings or small increases in core earnings and when actual earnings just meet or beat the analyst forecast in the fourth quarter. Moreover, our study sheds light on real activities management (RAM) research. Specifically, we find that managers engage in RAM of COGS to achieve the gross margin benchmark, but not core earnings benchmarks. For SGA, we show that unexpected SGA contain a significant expense misclassification effect, suggesting the importance to control for expense misclassification effect for future RAM research. Overall, our study extends prior expense management literature on both classification shifting and RAM.