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Do financially distressed firms misclassify core expenses?

Author

Listed:
  • Neerav Nagar
  • Kaustav Sen

Abstract

Purpose - This paper aims to examine whether financially distressed firms manipulate core or operating income through the misclassification of operating expenses as income-decreasing special items. Design/methodology/approach - This sample comprises firms in the USA with data from 1989 to 2010. The authors used the methodology given inMcVay (2006)and multiple regressions. Findings - Managers of financially distressed firms are more likely to inflate core or operating income as compared to the healthy firms to meet or beat earnings benchmarks. They do so by misclassifying core or operating expenses as income-decreasing special items. Specifically, core expenses are shifted to income-decreasing special items like goodwill impairments, settlement costs, restructuring costs and write downs. Practical implications - The paper sheds light on an important firm characteristic, financial distress that intensifies classification shifting – an earnings management tool which auditors, investors and regulators find tough to detect. The findings have implications for investors, as they fail to comprehend such shifting (McVay, 2006); analysts, who issue forecasts based on street earnings; lenders, as distressed firms may be concealing their true performance; and regulators, as the misclassification of income statement items is a violation of accounting principles. Originality/value - The authors extend the literature on accruals and real earnings management by the financially troubled firms and present first evidence that the managers of such firms also manipulate core or operating income through classification shifting.

Suggested Citation

  • Neerav Nagar & Kaustav Sen, 2017. "Do financially distressed firms misclassify core expenses?," Accounting Research Journal, Emerald Group Publishing Limited, vol. 30(2), pages 205-223, July.
  • Handle: RePEc:eme:arjpps:arj-04-2015-0054
    DOI: 10.1108/ARJ-04-2015-0054
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    Citations

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    Cited by:

    1. Frode Kjærland & Kristian Forbord & Are Oust & Håkon Stephani, 2023. "Management’s Discretionary Assessments of Goodwill Impairments—Evidence from STOXX Europe 600," IJFS, MDPI, vol. 11(2), pages 1-26, June.
    2. Ahsan Habib & Mabel D' Costa & Hedy Jiaying Huang & Md. Borhan Uddin Bhuiyan & Li Sun, 2020. "Determinants and consequences of financial distress: review of the empirical literature," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 60(S1), pages 1023-1075, April.
    3. Bansal, Manish & Kumar, Ashish & Bhattacharyya, Asit & Bashir, Hajam Abid, 2023. "Predictors of revenue shifting and expense shifting: Evidence from an emerging economy," Journal of Contemporary Accounting and Economics, Elsevier, vol. 19(1).
    4. Khalil Feghali & Reine Najem & Beverly Dawn Metcalfe, 2022. "Financial Auditing During Crisis: Assessing and Reporting Fraud and Going Concern Risk in Lebanon," Journal of Accounting and Management Information Systems, Faculty of Accounting and Management Information Systems, The Bucharest University of Economic Studies, vol. 21(4), pages 575-603, December.

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