Qualifying Special Items: An Identification and Examination of Lower-Quality versus Higher-Quality Income-Decreasing Special Items
Carol Anilowski Cain
Winston-Salem State University
Kalin S. Kolev
Yale School of Management
Sarah E. McVay
University of Washington
May 19, 2016
AAA 2009 Financial Accounting and Reporting Section (FARS) Paper
The frequency of special items has increased dramatically over time, both because of the underlying economics of firms, but also because of inappropriate misclassification of recurring expenses as non-recurring. Building on prior research, we propose a method to identify the higher- and lower-quality components of special items. We find that approximately two-thirds of the magnitude of the reported special items reflects appropriately classified, economically driven, transitory items that are not associated with future expenses, cash outflows, or restatements related to special items. The remaining one-third, however, we classify as lower-quality in that they are more likely to contain opportunistically misclassified recurring expenses that should have been recognized as such in prior, current or future periods. These lower-quality special items are associated with lower future earnings, lower future cash flows, and future restatements related to special items. We conclude that this portion of special items is more likely to contain expenses that would be better characterized as recurring. Our additional analyses examine the incentives to misclassify expenses (to meet the analyst forecast which generally excludes special items), as well as the effect of external monitoring on the prevalence of lower-quality special items (where more external monitoring is associated with fewer lower-quality special items). Finally, although our main models use future information, we present a modification that eliminates the need for forward-looking data and performs reasonably well. Thus, we provide meaningful partitions of special items that should be useful to investors, analysts, creditors, auditors and regulators, as each of these parties must assess the future implications of special items.
Number of Pages in PDF File: 58
Keywords: Special items, transitory items, earnings quality, earnings management, future operating cash flows, restatements
JEL Classification: M41, M43
Date posted: September 20, 2008 ; Last revised: May 20, 2016
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