On the Contemporaneous Reporting of Income-Increasing and Income-Decreasing Special Items: Initial Evidence

Abstract

Extant research finds that statement users typically discount special items in assessing a firm’s performance. Consequently, managers have been shown to highlight income-decreasing special items, in an effort to shift focus to “core” earnings, but strategically deploy and downplay income-increasing special items to boost bottom-line earnings. These dynamics suggest that the contemporaneous reporting of income-increasing and income-decreasing special items should be rare; however, this is not the case. We take a first step towards identifying the factors that guide this reporting practice. Using a novel dataset for a random sample of one hundred S&P 500 companies over twenty quarters, we analyze a set of potential drivers related to capital markets and contracting. Controlling for economic determinants, we find that the contemporaneous reporting of income-increasing and income-decreasing special items is linked both to efforts to avoid debt-covenant violations and to achieve earnings targets. Importantly, we find that the “equity-markets” effect manifests primarily for non-GAAP earnings. And, the “debt-markets” effect is driven by income-based covenants, not shielded from special items, and increases in covenant slack. As additional analysis, we confirm that the documented results generalize to a broad sample, based on machine-readable data, and the effect is most pronounced in settings where the use of alternative earning management methods is costly.