Core Earnings Research Articles

Factors Affecting The Choice of Core Earnings Management Tool

Prior studies document that managers manipulate core earnings through different methods to favourably influence the perception of stakeholders towards the operating performance of the firm. However, it is of interest to examine which core earnings manipulation method is preferred by firms because each method needs a different set of opportunities and incentives. The current study explores the methods of core earnings manipulation, namely expense misclassification and revenue misclassification in terms of opportunities and incentives. Results show that the choice of method largely depends on the size and age of the firm. In particular, results exhibit that large and old firms prefer revenue misclassification over expense misclassification for managing core earnings. This effect is found to be more pronounced among large older firms. Our subsequent tests suggest that Big Four auditors (Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers) have a constraining effect on expense misclassification, however, they are unable to mitigate the corporate misfeasance of revenue misclassification, implying the partial effectiveness of Big Four auditors in curbing classification shifting. These results are robust to the alternative measurement of misclassification practices and endogeneity issues. The findings have important implications for auditors, analysts, and accounting standard-setters.

The impact of R&D classification shifting in high-technology industries

PurposeThis study investigates the motivations and consequences of classification shifting from cost of sales to research and development (R&D) in high-technology industries.Design/methodology/approachThis study conducts a multivariate analysis using logistic and ordinary least squares regression methods on panel data of high-technology firms for the period 1988–2012 to examine the effect of R&D classification shifting on gross margin benchmarks and future performance.FindingsThe results show that R&D classification shifting increases the likelihood of meeting or beating gross margin benchmarks. They also show that firms engaged in R&D classification shifting exhibit lower future R&D productivity, stock returns, and operating performance. The findings indicate that the short-term benefits of achieving gross margin benchmarks are offset by the long-term negative impact of R&D misclassification.Practical implicationsThis paper provides insights that can help regulators develop clearer guidelines for the appropriate classification of R&D costs.Originality/valueMoving beyond the core earnings management paradigm, this study demonstrates the use of R&D classification shifting as a tool to manipulate gross profits and R&D in high-technology industries. Most prior studies focused on the determinants of R&D classification shifting, while few investigated the impact of the practice. The findings in this study provide initial evidence of the consequences of R&D classification shifting for future R&D productivity and firm performance in high-tech industries. Using five methods, this study also validates R&D classification shifting and addresses the alternative explanation of R&D overinvestment.

Forecasting Market Volatility: The Role of Earnings Announcements

ABSTRACT This study examines whether information revealed by firms’ earnings announcements (EAs) forecasts short-run market-wide volatility in equity index prices. Using an exponential generalized autoregressive conditional heteroskedasticity model that includes controls for the information in an array of macroeconomic announcements, we find that EA information aggregated across firms forecasts market volatility at daily and weekly intervals. EA information’s forecasting power is greatest when more firms announce earnings on a given day, when EAs convey negative news, and for EA information about core earnings. Out-of-sample tests confirm that forecasts incorporating EA information better predict short-run market volatility than forecasts omitting EA information. We conclude that firm-level EAs are a significant source of systematic, market-wide information relevant for predicting near-term market volatility. Data Availability: All data are publicly available from sources cited in the text. JEL Classifications: E44; G12; M41.

A single-step firm-level identification of classification shifting

PurposeThis study proposes a new model to measure unexpected core earnings, using Bayesian dynamic latent method.Design/methodology/approachThe Bayesian dynamic latent modeling approach identifies the effects that stem from complex, multidimensional variables related to culture and legal framework, on unexpected core earnings. It also allows testing whether there is persistence over time in unexpected core earnings. We use sequential Bayesian Monte Carlo methods, also known as particle filtering, that simplify estimations.FindingsIn an international empirical application, we find evidence of persistence in unexpected core earnings as well as classification shifting. The impact of the legal framework on classification shifting shows variability across samples. Religion reduces classification shifting, whereas the cultural variables of power distance, masculinity and uncertainty avoidance enhances it. Interestingly, the persistence in unexpected core earnings is strong and moderates the ability of legal framework and religion in abating classification shifting.Research limitations/implicationsIn terms of policy implications, we show that strengthening legal framework would improve financial reporting and reduce the scope for manipulation. This could involve stricter enforcement mechanisms, increased penalties for non-compliance and regular audits to detect and deter classification shifting practices. Given that religion plays a role in moderating classification shifting, policymakers may explore partnerships or collaborations with religious institutions to promote ethical financial practices. Engaging religious leaders and organizations can help emphasize the importance of integrity and ethical behavior in financial reporting, potentially influencing the behavior of individuals and organizations.Originality/valueTo the best of our knowledge this is the first study that opts for Bayesian dynamic latent model for an international sample.

Does short selling reduce classification shifting?—— Exploration of market-oriented governance mechanism

We empirically investigate the impact of short selling on classification shifting, exploiting the staggered lift of short-sale bans in China. Using a multi-period difference-in-difference research design, we find that the lift of short-sale bans mitigates the classification shifting. We also find that short selling alleviates the market's overpricing of the core earnings of firms engaging in classification shifting, thus reducing the expected benefits and motivations of firms for classification shifting. Further research shows that short selling has a more significant inhibitory effect on classification shifting in regions with developed financial intermediaries and it improves the persistence of core earnings.

The Influence of earnings volatility on the relationship between leverage and classifications shifting earnings management: An Entrepreneurial view

This study investigates the relationship between leverage and classifications shifting earnings management and how this relationship is influenced by earnings volatility. To achieve the research objective, this study takes the sample of Pakistani non-financial firms listed in Pakistan Stock Exchange for the period of 2004 to 2018. This study discusses the relationship between leverage and classifications shifting earnings management, especially with the interaction of earnings volatility. The study is supported with the Agency Theory and Positive Accounting Theory using the two-step system Generalized Method of Moment (SYS-GMM) dynamic panel estimators. The leverage is measured by using long term debt, short term debt and total debt while earnings volatility captured the measurement of business risk and for the measurement of classifications shifting is used as earnings management. To capture the classifications shifting, McVey model is used that measures the core earnings. Firstly, the study examines the relationship between leverage and classifications shifting earnings management and after that how earnings volatility influences that relationship. The results showed that relationship between classifications shifting and leverage and is positive but when an interaction term is used as earnings volatility it shows negative relationship between classifications shifting and leverage. So when the firm needs debt in the shape of leverage, it misclassifies the core earnings in the income statement but when there are fluctuations in the earnings like earnings volatility of firm it avoids to use classifications shifting due to professional assessment of the financial institutes and brokers of financial markets. So, in the entrepreneurial firms the managers avoid to use earnings management because these managers keep and show the true financial representations of financial statements.

Managerial overconfidence and classification shifting

This study examines whether overconfident CEOs engage in classification shifting. We find that managerial overconfidence is related to an increase in unexpected core earnings via reclassifying recurring expenses as special items. This finding is robust to controlling for firms’ propensity to engage in accruals management and real earnings management, using a subsample of non-zero income-decreasing special items, employing alternative measures of overconfidence, and controlling for CEO and firm fixed effects. We further find that overconfident CEOs are more likely to engage in classification shifting when the incentives are stronger, i.e., when CEOs want to meet or beat analyst forecasts, when CEOs’ pay is highly sensitive to core earnings, and when CEOs have low managerial ability. Overconfident CEOs are also more likely to engage in classification shifting when there are more opportunities for misconduct, i.e., when financial statement comparability is low and when the CEO can use opportunistic special items to misclassify expenses. Overall, we find that overconfident CEOs are intentionally, rather than unintentionally, engaging in classification shifting to boost core earnings.

Core Earnings Incentive Contracts and Classification Shifting

Core Earnings Incentive Contracts and Classification Shifting

Classification Shifting and Earnings Predictability

The literature measures classification shifting as the relation between unexpected core earnings and income-decreasing special items. The general view in this literature is that managers shift core expenses to special items to inflate core earnings to achieve self-motivated reporting objectives. However, an additional possibility is that classification shifting helps investors better predict future performance. We find evidence of this positive consequence of classification shifting. Our study raises the possibility that measures of classification shifting in certain settings do not reflect managers’ opportunistic reporting. Given the relatively limited evidence in the literature on the consequences of classification shifting on investors, we believe these findings need to be considered as the literature moves forward.

Classification Shifting and Future Stock Price Crash Risk

AbstractWe examine whether classification shifting is associated with stock price crash risk. Unlike prior studies, our study is focused on bad news hoarding through classification shifting. Prior studies document evidence of the greater weight market participants place on core earnings and stock price crash resulting from delayed bad news releases. Building upon these findings, we predict that crash risk is positively associated with shifters’ reversal of core earnings. Consistent with our conjecture, we find that classification shifting is positively associated with future stock price crash risk even if the bottom‐line net income is unchanged. This finding is robust after controlling for endogeneity and other determinants of classification shifting. We also find that the observed positive association between classification shifting and future stock price crash risk is pronounced for likely opportunistic classification shifters. Our research contributes to forming an enhanced understanding of crash risk by documenting differential negative market reactions to the change in core earnings driven by classification shifting.

The BP oil spill and income classification shifting of oil and gas companies

Literature has documented income classification shifting to increase core earnings. There has been little research on whether firms reduce income increasing classification shifting or classification shift to reduce core earnings - classify non-core items as core expenses. Also, research on classification shifting under non-market incentives is limited. We fill these gaps by examining the shifting behavior of oil and gas firms in response to the BP oil spill. The oil spill was an unexpected event that led to regulations and restrictions, as well as adverse publicity. This could have encouraged petroleum firms to suppress core earnings. We show that after the oil spill, (1) the likelihood of petroleum firms' classification shifting to inflate core earnings declines relative to other firms and (2) the likelihood of petroleum companies' shifting to report lower core earnings increases relative to other firms.

Audit quality and classification shifting: evidence from UK and Germany

PurposeThe authors examine the impact of audit quality (AQ) on classification shifting (CS) among non-financial firms operating in the UK and Germany.Design/methodology/approachThis paper used various audit committee variables (size, meetings, gender diversity and financial expertise) to measure AQ and its impact on CS. The authors used a total of 2,110 firm-year observations from 2010 to 2019.FindingsThe authors found that the presence of female members on the audit committee and audit committee financial expertise deter the UK and German managers from shifting core expenses and revenue items into special items to inflate core earnings. However, audit committee size is positively related to CS among German firms but has no impact on UK firms. The authors also document evidence that audit committee meetings restrain UK managers from engaging in CS. However, the authors found no impact on CS among German firms. The study results hold even after employing several tests.Research limitations/implicationsOverall, the study findings provide broad support in an international setting for the board to improve its auditing practices and offer essential information to investors to assess how AQ affects the financial reporting process.Originality/valueMost CS studies used market-oriented economies such as the USA and UK and ignored bank-based economies such as Germany, France and Japan. The authors provide a comparison among bank and market-oriented economies on whether the AQ has a similar impact on CS or not among them.

Corporate Social Responsibility and Revenue Misclassification: Evidence from India

The study examines the relationship between Corporate Social responsibility (CSR) and revenue misclassification in Indian institutional settings. Malikov et al. model has been used to operationalise revenue misclassification. Using a sample of Bombay Stock Exchange listed firms spanning over 14 years (March 2009 until March 2022), I find that CSR-oriented firms prefer revenue misclassification over expense misclassification for managing core earnings, consistent with the notion that CSR firms prefer earnings management (EM) tool having a greater relative advantage in terms of reporting favourable operating performance metrics. The subsequent tests suggest that big four auditors have a constraining effect on the revenue misclassification practices of firms. The findings alert auditors about the suspected firms (high-CSR firms) that are more likely to manage earnings through revenue misclassification and suggest authorities make more mandatory disclosure requirements for recording revenue items to curb the corporate misfeasance of revenue misclassification.

Classification shifting using income-decreasing special items: measurement and valuation issues

Research suggests that the standard model used to detect opportunistic shifting of core expenses to special items is potentially biased. Such bias has been attributed to the use of accruals, including special item related accruals, as a control for the impact of performance on core earnings in this model. This paper provides an improved classification shifting model which both tests for such accruals-related bias and controls for other sources of error in the measurement of shifting. The paper also modifies conventional market rationality tests in accounting research to examine new dimensions of rationality in relation to measurement and valuation of shifting. The main empirical findings are as follows. First, the improved classification shifting model provides strong evidence of shifting and rejects the hypothesis that inclusion of accruals in the model causes bias. Second, estimates of shifted core expenses generated by the improved model exhibit forecasting properties of shifted earnings. Third, rationality test results are broadly consistent with rationality in relation to shifted core expenses but indicate possible partial (ir)rationality in relation to adjusted special items (i.e., special items excluding shifted core expenses). Further analysis of the latter findings, however, suggests they are more likely related to risk than irrationality. Overall, the paper contributes to improved measurement of shifting and highlights the importance of considering rational expectations when examining stock returns associated with shifting.

Pension accounting information and firm value: An analysis of FTSE 100 companies

This study is among the first to take known results in pension accounting and use a sample of UK listed FTSE 100 companies to show that the results are mostly the same as in previous research (on the US companies) into associations between pension accounting information and firm value. We investigate the association between published pension accounting information and the market value of a sample of UK listed FTSE 100 companies in the ten-year period 2006 to 2015. We analyse UK listed firms that report under the IFRS accounting framework (IAS 19), which is a contribution to earlier literature that concentrated on US listed firms that report under the US (FASB) accounting framework that has significantly different pension accounting rules to the IFRS accounting framework. Moreover, the analysis is conducted on a sample of firms that used the method of immediate recognition of actuarial gains and losses in other comprehensive income (or the ‘Fair Value OCI method’) even before mandatory adoption of this method from 2013. We employ a static panel regression analysis on a sample of 70 companies. Empirical findings suggest that there is an association between pension accounting information and firm value, but in some cases, there is less association than there is between other types of accounting information and firm value. Core earnings are value relevant but overall pension earnings (net) are not value relevant although pension costs, pension interest expense and pension income have an association with firm value. Balance sheet numbers have less association with firm value than is the case for core earnings, pension costs, pension interest expense or pension income.

Revenue Classification Shifting: Does CEO Gender Matter?

Instead of managing bottom-line earnings, firms may use revenue classification shifting to inflate core earnings due to its less risky, less costly, but viable features. Female CEOs, being perceived more risk-averse and more ethical, may engage in either more or less revenue classification shifting than male CEOs. Using a sample of 36,427 US firm-year observations from 1993 to 2019, we find that female CEOs tend to engage in less revenue classification shifting than male CEOs when the monitoring environment is looser but increase revenue classification shifting when the monitoring environment becomes more stringent. Further analyses indicate that female CEOs may substitute revenue classification shifting for more costly earnings management tools under stricter monitoring. The results are robust to endogeneity tests, sample selection bias, and additional control variables, providing new evidence that female CEOs are more risk-averse.

The impact of board characteristics on classification shifting: evidence from Germany

PurposeThis paper aims to examine the relationship between board characteristics (BCs) on classification shifting (CS) among listed non-financial German firms.Design/methodology/approachUsing 870 firm-year observations of German non-financial firms from 2010 to 2019 listed on DAX, MDAX and SDAX index, this paper examines the relationship between BCs (board size [BS], board meetings [BM], board independence [BI] and board gender diversity [BGD]) and CS.FindingsThis study found that managers of German firms use CS and move recurring expenses to non-recurring expenses to inflate their core earnings. Also, this study found that BCs including BS, BI and BGD have a mitigating effect on CS practices of German non-financial firms. However, the number of BMs does not influence earnings management.Practical implicationsThis paper recommends that German firms’ board must be constituted with more independent members and female representation because these board mechanisms help to curb CS.Originality/valueThe focus of this study is Germany, which is a bank-oriented economy with low transparency and investor protection. This paper provides new evidence on how BCs impact CS among German firms, whereas previous CS studies focused mainly on market-oriented economies like the USA and the UK.

Moderating Effect of Dynamic Capabilities on the Relationship Between Porter’s Generic Strategies and Performance of Commercial Banks

The Kenyan banking industry contributes significantly to government revenues yet financial reports indicate that Kenya’s listed banks recorded a negative EPS (earnings per share) growth of 0.8% in the financial year 2017, compared to average positive growth of 4.4% in the financial year 2016. Kenya’s listed published their financial year 2018 performance, with an average growth share, of 13.8%, compared to 1.0% decrease the past year. All quoted banks in Kenya gave their financial year 2019 reports, realizing average core earnings per share growth of 9.9%, in comparison to 13.8% growth, in the past year. This trend indicates a decline in the growth of the core earnings per share. Previous studies on dynamic capability and performance dwelt on sensing capability, coordination, learning, sensing, seizing, transforming, and IC. However, this study focused on all dynamic capabilities. Past studies on the moderator influence focused on alliance management capability, resource planning capability, and environmental dynamism as moderators. However, this study focused on all the dynamic capabilities of the moderator. This demonstrates that dynamic capability is still a plausible moderator. This study focused on the listed banks currently 11 in number. This is because their operations and records Were declared by law to the public. Objective one was regressed from the dependent and the independent variables. In objective two there was the introduction of the dynamic capabilities’ variable to establish its effect on the outcome. Objective three combined the dependent, independent variables and the potential moderating variable. The study applied the resource base theory because it looks at the role of internal aspects, that is resources and capabilities- of the organization during change. Also, the configuration theory because it believes in organizational rejuvenation and restructuring of their core structures to achieve success. Cross-sectional survey design with a census done of the listed commercial banks in Kenya, was adopted. The respondents comprised 68 heads of departments, 11 CEOs, 29 regional heads, and 145 regional managers. Primary data collection was done vide a questionnaire. Reliability was ascertained using Cronbach’s alpha test. The performance scale should indicate a Cronbach alpha of at least 0.7. Face validity was ensured by administering the questionnaire to two senior bank managers. construct validity was established. Content validity was ascertained through the subjection of a pool of questions to experts. Data analysis was done using descriptive and inferential statistics. The results discovered that generic strategies by porter, affected commercial banks' performance, (β=0.645, p=0.000) and accounted for 41.6% variance, dynamic capabilities positively affect performance (β=0.364, p=0.000) and account for 12.9% and dynamic capabilities are a positive moderator of the relationship between porters’ generic strategies and performance (β=0.030, p=0.010) with a percentage increase of 1.5%. It is concluded from the findings that porter’s generic strategies and dynamic capabilities have positive effects on the performance of commercial banks while dynamic capabilities moderate the relationship. It was recommended from the findings that companies improve more on the cost strategy and dynamic capabilities to realize better performance. The study would contribute to the existing literature by adding the moderating effect of dynamic capabilities. The study will help bankers to focus on dynamic capabilities while studying performance. The academia will benefit from this study as well.

Do independent directors and big-4 audit firms limit classification shifting: evidence from Indian firms

PurposeThis study investigates the moderating role of Big-4 audit firms on the association between board independence and classification shifting (CS) in Indian firms.Design/methodology/approachThis study has employed a fixed-effect panel data regression model to analyze the sample data. Board independence is measured by taking the proportion of independent directors on a firm’s board. CS is measured from the core earnings expectation model (McVay, 2006). Principal Score Matching is applied to validate the results.FindingsBased on 6,016 firm-year observations of Indian firms listed on the Bombay Stock Exchange, results show that firms with a higher proportion of independent directors on board are effective in limiting expense CS. Further, firms that Big-4 audit firms audit play a significant role in curbing expense CS. Overall, results also exhibit that Big-4 audit firms significantly influence the association between board independence and CS.Originality/valueThis study is one of its kind to examine the moderating role of Big-4 audit firms between board independence and CS.

Effect of Dynamic Capabilities on Performance of Commercial Banks

The Kenyan banking industry contributes significantly to the government revenues yet financial reports indicate that Kenya’s listed banks recorded a negative EPS (earnings per share) growth of 0.8% in the financial year 2017, compared to average positive growth of 4.4% in the financial year 2016. Kenya’s listed published their financial year 2018 performance, with an average growth a share, of 13.8%, compared to a 1.0% decrease the past year. All quoted banks in Kenya gave their financial year 2019 reports, realizing average core earnings per share growth of 9.9%, in comparison to 13.8% growth, in the past year. This trend indicates a decline in the growth of the core earnings per share. Previous studies on dynamic capability and performance dwelt on sensing capability, coordination, learning, sensing, seizing, transforming and IC. However, this study focused on all dynamic capabilities. Past studies on the moderator influence focused on alliance management capability, resource planning capability, and environmental dynamism as moderators. However, this study focused on all the dynamic capabilities of the moderator. This demonstrates that dynamic capability is still a plausible moderator. This study focused on the listed banks currently 11 in number. This is because their operations and records Were declared by law to the public. Objective one was regressed from the dependent and the independent variables. In objective two, the dynamic capabilities variable was introduced to establish its effect on the outcome. Objective three combined the dependent, independent variables and the potential moderating variable. The study applied the resource base theory because it looks at the role of internal aspects – resources and capabilities – of the organization during change. Also, the configuration theory because it believes in organizational rejuvenation and restructuring of their core structures to achieve success. Cross-sectional survey design and correlational was done of the eleven listed commercial banks in Kenya. The respondents comprised 68 heads of departments, 11 CEOs, 29 regional heads, and 145 regional managers. Primary data collection was done vide a questionnaire. Reliability was ascertained using Cronbach’s alpha test. The performance scale should indicate a Cronbach alpha of at least 0.7. Face validity was ensured by administering the questionnaire to two senior bank managers. construct validity was established. Content validity was ascertained through subjection of a pool of questions to experts. Data analysis was done using descriptive and inferential statistics. The results discovered that generic strategies by porter, affected commercial banks’ performance, (β=0.645, p=0.000) and accounted for 41.6% variance, dynamic capabilities positively affect performance (β=0.364, p=0.000) and accounts for 12.9% and dynamic capabilities are a positive moderator of the relationship between porters’ generic strategies and performance (β=0.030, p=0.010) with a percentage increase of 1.5%. It is concluded from the findings that porter’s generic strategies and dynamic capabilities positively affect commercial banks' performance while dynamic capabilities moderate the relationship. It was recommended from the findings that companies improve more on the cost strategy and dynamic capabilities to realize better performance. The study would contribute to the existing literature by adding the moderating effect of dynamic capabilities. The study will help bankers to focus on dynamic capabilities while studying performance. The academia will benefit from this study as well.